Friday, April 18, 2008

70s Redux

Vincent Reinhart explains food inflation on the editorial page of the WSJ:

What is going on? We can discern four forces at work today pushing up food prices – forces that were also at work in the 1970s, the last time food prices increased so rapidly on a sustained basis:

- Monetary policy in overdrive. Consider the real federal funds rate – that is, the nominal funds rate less inflation. A low real fed funds rate both encourages interest-rate sensitive spending, such as business investment, and discourages global investors from supporting the dollar on foreign exchange markets. At 2.25%, the nominal fed funds rate is now below the prevailing rate of consumer price inflation.

The last time the real fed funds rate was negative for a prolonged period was the mid-1970s. This was also a period when overstimulated demand pushed food prices up and the dollar depreciated sharply. In the end, economic growth suffered as well. Remember stagflation?

- Exchange-rate arrangements in disarray. The 1970s were also noted for turmoil in exchange markets, following the breakdown of the Bretton Woods system. The schism today is that some exchange rates move too little and others too much.

The exchange rates that are moving too little are those of emerging market economies and oil producers. China, India, Korea and Taiwan, and key oil producers such as Saudi Arabia, have been preventing their exchange rates from appreciating significantly by rapidly accumulating international reserves.

They've also effectively adopted the monetary policy of the Federal Reserve by keeping their domestic interest rates close to the fed funds rate. That way, no interest-rate wedge opens between their markets and our own that would otherwise put pressure on their exchange rate. As a consequence, they are following an accommodative monetary policy strategy totally unsuited to their already overheated domestic economies. Higher inflation has followed.

With exchange-rate movements capped by policy makers in so many parts of the world, the burden of adjustment falls more heavily on the nations that allow their currencies to float freely, such as Canada, those in the Euro area, and Japan. The depreciation of the dollar against these currencies is yet another reminder of the 1970s. As a result of these exchange-rate changes, the purchasing power of these regions for any internationally traded good denominated in dollars has gone up. Hence, it is no accident that the dollar price of food is up sharply.

- Unsound market interventions. Policy makers flailed about in the 1970s, enacting environmental legislation without due deference to the costs imposed on industry. They also tried to impede market forces with gasoline rationing and a brief flirtation with outright price controls.

This time round, our government has been force-feeding the inefficient production of ethanol. The result: Corn prices have more than doubled over the past three years, adding to price pressures on commodities that are close substitutes, or which use corn as an input to production.

Meanwhile, policy makers in emerging market economies have bent under the weight of popular unrest to raise food subsidies. This strains their budgets. They are also imposing restraints on exports, thereby losing gains from trade.

- Oil prices on the rise. The lines stretching around filling stations in the 1970s should remind us that large energy-price increases are disruptive. And we have had a large one: Crude prices have more than quadrupled since 2001. Any industry dependent on energy will feel those cost pressures, and modern agriculture, with its oil-based fertilizers and large machinery, is no exception.

But there is an important difference between our troubles today and those of the 1970s. In that decade, aggregate supply sagged as oil producers scaled back production and anchovies disappeared off the coast of Peru. The 2000s have been about demand expansion. Millions of workers in China, India and Vietnam, among others, have joined the world trading system. Beginning from a point close to subsistence, most of their additional income is being spent on food. Thus, the price of food relative to other goods and services has risen.

The good news is that producers respond to relative prices, although it can take some time. Already, the acreage in which corn is planted in the United States is back to levels of the 1940s. More of a production response should follow in other areas as well.

Challenges abound as supply catches up with higher global demand. The Federal Reserve has to be sensitive not to stoke inflation pressures, and to monitor inflation expectations closely. The subsidies proffered to corn producers have to be trimmed, in part to set a new standard for emerging market economies to emulate. And the gains from an open trading system have to be protected to keep our economy efficient.

This mirrors themes I've been harping on here for a while, but this is well said.

No comments: