Food Cost, Inflation and Monetary Policies in Developed Markets

by: Zhong Jin

The latest released inflation data in developed economies so far have appeared to be in line with the market expectation. U.S. inflation in January is 1.6%, higher than that in previous months, but still well below the Fed’s inflation target. Inflation rates in U.K. and Germany are rising fast; U.K. inflation in January is up to 4%, driven by surging food, oil, and commodity prices. This inflation rate is already double the inflation target (2%) set by BOE. German inflation in January rose 2% from a year ago, and was the highest annual growth rate since October 2008. The inflation target of ECB is "close to but below 2%."

Regarding the policy implication of these inflation numbers, the Fed will definitely go along with QE2 and low interest rates as planned, since the inflation threat is still low on their list. Concerning the PIIGS debt problems, the ECB will only pay lip service when it comes to inflation, especially when the next central banker in ECB looks likely to be Italian. BOE will avoid the monetary tightening as well. It had persistently done so in 2010, when U.K. inflation had been above 3% for most of the year. The U.K.'s negative employment change in January will be another excuse for BOE to continue ignoring the elephant in the room.

The major driver behind global inflation today is food cost. Emerging markets are affected more than others since food costs account for a much larger portion of their consumer expenditure. For developed markets, it is more complicated. U.K. food cost is closely linked to international markets. In December 2010, the trade deficit in the category of food, beverage, and tobacco accounted for nearly one-third of the monthly trade deficit. As agricultural commodity prices continue spiking in international markets, food inflation in U.K. is likely to further rise. Based on historical data, the headline inflation in U.K. usually moves with food inflation. Even though BOE estimated that the implementation of fiscal austerity policies would probably help contain inflation, inflation fueled by surging food costs could be more persistent than people think, if history is any guide.

Food inflation in the US so far is subdued. The long term food inflation after 2000 in the U.S. is 2.7%, far higher than January food inflation of 1.8%. But if we look at agricultural commodity prices, the annual growth rate of Dow Jones-UBS Agricultural Commodity Price Index in January 2011 is 43.84%. When annual growth rates of this index were at similar levels in the first half of 2008, the average food inflation was 4.9%. Since then food manufacturers have had to absorb rising input costs. Now the capacity utilization in the food industry is 78.45, slightly lower than the average capacity utilization rate in the first half of 2008 (78.95). The question remains how much longer food manufacturers can keep the hiking input costs from being passed on to consumers in the U.S.

Loose monetary policies from central banks of developed countries have taken their toll on commodity prices. The expectation of immediate policy changes is fading as reasons of not changing course right now are ample for central bankers in developed economies. Agricultural commodities will continue to be the group of assets that receive the most interest.

Although agricultural commodity prices and agricultural ETFs are now at record highs, in the next few weeks they can move even higher. Major diversified food companies, especially those with a large share of revenue from the U.S. market, are ones that get squeezed by high commodity prices and low food inflation. As such, companies such as Kraft (KFT) and Heinz (HNZ) may lag behind the market for now.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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