Will the Fed React to Rising Food Inflation?

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Rising food price and core inflation may lead to a reaction from the Fed.
Food price inflation is increasing sharply in the US. Only last December 2013, food prices were just 1.05% higher than the previous December. As of May 2014, food price inflation was running at 2.46% (year over year) and possibly heading above 4% by late 2014 or early 2015.

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Will the Fed React to Rising Food Inflation?

  1. 1. 1 MARKET INSIGHTS Food Price Inflation, Drought, and El Nino Possibility nsightsMarket JULY 14, 2014BY BLU PUTNAM, CHIEF ECONOMIST, CME GROUP HEIDI CENTOLA, MANAGER, AGRICULTURAL AND ALTERNATIVE INVESTMENT PRODUCTS, CME GROUP Will the Fed React to Rising Food Inflation? Food price inflation is increasing sharply in the US. Only last December 2013, food prices were just 1.05% higher than the previous December. As of May 2014, food price inflation was running at 2.46% (year over year) and possibly heading above 4% by late 2014 or early 2015 (See Figure 1). Of course, the Federal Reserve (Fed) prefers to target core inflation, which leaves out the volatile food and energy sectors, and lessens the chances of a head-fake in the data. When food inflation is rising along with incremental increases in core inflation, however, the Fed can be expected to take this into consideration. And, over the last three months, there have been signs of incremental increases even in core inflation (See Figure 2). Couple these two inflation developments with the unemployment rate likely to decline below 6% in the second half of 2014, then the probabilities increase for the Fed to raise its target federal funds rate sooner rather than later in 2015 – perhaps as early as the FOMC meeting scheduled for 17-18 March. Figure 1. Figure 2. California and North Texas Droughts Water Resource Challenges Higher food prices in the US are primarily related to the droughts in the vegetable and fruit growing areas of California as well as the livestock regions around north Texas and southern and western Oklahoma. The severity of the drought in California should not be underestimated, and its long-term implications for water management are quite challenging. As water resources are stretched thinner and thinner, it puts various user groups, from residential to energy extraction, to industrial, to agricultural, in conflict. Moreover, water resources cross state and sometime national boundaries, making coordination exceptionally difficult. And, because water lies at the nexus of both agriculture and energy, water resource challenges have the ability to impact the US economy in many longer-term ways, well beyond the obvious implication of higher food prices when a bread-basket region is affected by drought.
  2. 2. JULY 14, 2014 2 MARKET INSIGHTS Figure 3. El Nino Possibility with Implications for India, Australia, and Possibly the US As we monitor the drought in California, it is also important to take note that there are signs over the equatorial Pacific Ocean of the warmer than usual water temperatures that have the potential to give rise to an El Niño event. If, and this is by no means a certainty yet, an El Niño event were to develop, then the impact on weather patterns around the world can be quite striking, yet with many of the effects coming with a lag. The direct impact of warmer water is more evaporation and then more precipitation, depending on where the winds blow. And because El Niño events are associated with oscillations in air pressure patterns, wind and jet stream track shifts can drive where the rain (or snow) falls and where it does not. Figure 4. Please note that while sea surface temperatures are currently above average in the equatorial Pacific, they have not yet reached the intensity level of an El Niño event. Indeed, in June there was some slight weakening of the temperatures. Most El Niño experts, however, still see a high probability of one developing slowly in the second half of 2014. If an El Niño event occurs, we would expect more rain in Ecuador and Peru, southern Brazil and northern Argentina, and Indonesia, but less rain in the breadbasket regions of Australia and India. Depending on the severity of the drought, should it occur, India would import more food and grains, while Australian exports might decline. This has the potential to put upward pressure on world grain prices, especially wheat, even if there were no problems with production in Canada and the northern US. And, an El Niño event does have the potential to produce a slighter warmer winter weather in the US and Canadian grain growing regions, without causing a drought. We should note, however, that the US effects come with a time lag. The most impactful effects in the Northern Hemisphere are more likely late winter or next spring should an El Niño event actually form. The typical El Niño pattern for the US is to shift the storm track downward across the southern parts of the US, which can mean less
  3. 3. JULY 14, 2014 3 MARKET INSIGHTS stormy and milder winters in the northern sections of the country. The California drought could be eased in the process of the storm track shifting southward, but with a greater probability of quite severe weather. Hurricane formation is also potentially impacted by the shifting wind patterns, which can lessen the ability of the storms to develop off the west coast of Africa in the tropical Atlantic. Hurricanes may still form, as Arthur did in early July, in the warm waters southeast of Florida and in the Caribbean Islands. What El Niño events underscore is how connected world weather patterns are, which emphasizes the global nature of agricultural markets. All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience. To read more of our Market Insights, visit cmegroup.com/marketinsights CME Group is a trademark of CME Group Inc. The Globe Logo, CME, Chicago Mercantile Exchange and Globex are trademarks of Chicago Mercantile. Exchange Inc. CBOT and the Chicago Board of Trade are trademarks of the Board of Trade of the City of Chicago, Inc. New York Mercantile Exchange and NYMEX are registered trademarks of the New York Mercantile Exchange, Inc. COMEX is a trademark of Commodity Exchange, Inc. The information within this brochure has been compiled by CME Group for general purposes only. CME Group assumes no responsibility for any errors or omissions. Although every attempt has been made to ensure the accuracy of the information within this brochure. Additionally, all examples in this brochure are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience. Copyright © 2014 CME Group. All rights reserved.

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