Global Economic Outlook and Strategy - Kadin Indonesia

February 28, 2008
Global Economic Outlook and Strategy
The recent supply shock
is small relative to past
shocks.
Rising food prices are a
particular concern.
Demand for biofuels has
pushed up food prices...
...but the boost is not
large.
Food price increases are
relative price increases.
To affect inflation, relative
price increases have to be
large and persistent.
Richer economies spend a
smaller proportion of
income on food.
Second, stagflation would need to arise from large supply shocks that drive up costs
significantly. Much of the rise in commodity prices in the past few months can be linked to
supply shocks, but in the aggregate they do not look as abrupt and large as the oil price
shocks of 1973 and 1979 that prompted ensuing periods of stagflation. The average price
of WTI crude oil shot up 168% between 1973 and 1974, 166% between 1979 and 1980,
and just 58% year to year in February 2008.
Some investors cite concerns about a secular rise in agricultural prices, driven by a
combination of higher demand for some foods as a source of biofuel, rising incomes in
emerging markets, and more unpredictable weather. While arguments that these forces will
continue to drive up food prices may have some merit, the increases in overall emerging
market inflation in 2008 should be much more muted for several reasons.
First, some researchers do find sustained pressure on wheat, corn, soybean, and palm oil
prices from aggressive expansion of biofuels. However, the implied increases are small
relative to recent price gains. For example, an International Food Policy Research Institute
study finds increases that cumulate to 15%-30% for wheat over the next 12 years and 20%-
40% for corn. 2 But these figures are all less than the price rises in these products in the
past 18 months as oil prices have nearly doubled. A renewed surge in energy prices could
fuel another round of food price increases, as it would shift demand toward biofuels. But
any increase in energy prices is unlikely to be as steep as the runup in the past year. That
alone should dampen food price inflation.
Furthermore, the pressure on food prices from increased demand for biofuels would occur
mainly under circumstances that are unlikely to persist — that is, no improvement in the
efficiency of biofuels production and the continuation of U.S. and EU government
subsidies. The rise in oil prices has boosted the profitability of producing biofuels, which
is likely to encourage improved efficiency. Rising food prices may alter some of the
public’s support for subsidies to biofuel production and eliminate the need for government
programs to artificially restrain agricultural production as a support for farm incomes.
Second, increases in food prices are an increase in relative prices, not in the absolute price
level. With a larger proportion of income spent on food bills, less money is available to
spend on other products, which tends to dampen those other product’s prices and offset the
initial shock, leaving the general price level unchanged.
Relative prices can influence inflation if adjusting prices is costly so that firms absorb
small changes rather than pass them on to consumers. Thus, only large changes get
reflected in price measures. 3 In the case of a relative price shock, such as the recent rise in
food prices, a large price change in one sector is not offset by small opposite adjustments
in prices of other products. However, for inflation to persist, future large shocks would
need to occur.
Third, rising incomes can alter the sorts of food that people demand and, over time, reduce
the proportion of income spent on it. This can be seen in the lower share of consumer
baskets spent on food in high-income countries (15%-20% versus 35%-40% in emerging
markets). The shifting pattern of food consumption can also be seen in the rising demand
2
See von Braun, Joachim, and P. K. Pachauri, Essay: The Promises and Challenges of Biofuels for the Poor in Developing Countries,
International Food Policy Research Institute, 2006.
3
For a discussion of inflation, relative prices, and the skew in their changes, see Ball, Laurence and Greg Mankiw, “Relative-Price Changes as
Aggregate Supply Shocks,” Quarterly Journal of Economics, Vol. 110: No. 1 (Feb, 1995) pp. 161-193.
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