Agflation – Pay More To Eat

crop.JPG‘Agflation’- rising food prices or end of cheap food is the new buzzword doing rounds in places of inflation trackers, central banks and politicking parties coming up with price control to fight agflation.

World food prices are on a rise. In September alone, it had doubled to over $400 a tonne from $200 a tonne in May. Rise in price of one crop has effects on other crops as well with supply side mechanism coming into play. To maximize gains from high prices of one crop, farmers plant more of that crop replacing other crops. In this case, the rise in price of wheat led farmers to produce more of it and the price of rice also rose in response to reduced supply of rice which was replaced by wheat.

A quick introspection in the usual causes of rise in food prices leads one to conclude that the rising prices reflect scarcity of that commodity resulting from crop failure. But what is truly astounding about the sky rocketing food prices is that this phenomenon is taking shape through face of abundance rather than its scarcity. Indeed, this year, total cereal crop will be 1.66 billion tonnes which is 89 million more than last year, according to International Grains Council, a trade body based in London. A sharp eye will have to probe deeper into fundamentals to unravel the reason behind the incongruous behavior of world food prices. Two reasons come to the forefront. First is the rising income in India and China which is pushing up demand for meat in these countries. This, in turn, builds up the requirement of grains to feed animals. The other reason is the rise in use of ethanol, as an alternative fuel and the solution for pollution, which requires maize to be produced from. These reasons demand explanation.

The rising wealth in the two Asian giants, India and China, is complementing the rise in meat consumption and, hence, the demand for meat. In other developing countries as well, the demand for food grains has been stable while that for meat has nearly doubled since 1980. In tandem, the farmers are feeding 200 million to 250 million more tonnes of grains to their animals than they were twenty years ago. Also, it takes more of grains to produce meat: 3 kilos of grain to produce 1 kilo of pork and 8 kilos of grain to produce 1 kilo of beef. Such a shift in diet has pushed up prices of grains by increasing the overall demand for cereals. But this incremental change in diet cannot be the only burden causing the dramatic increase in food prices.

There has been a surge in use of ethanol as fuel for American cars, supported and encouraged by the government. Ethanol, which is produced from maize, has become an alternative fuel; the US government has embarked upon an ethanol programme which is mainly a programme of subsidies and tariffs on import of ethanol like that from Brazil where ethanol is made from sugar instead of maize. Due to this, the maize production in the American economy has increased drastically to a jaw-dropping 355 million tonnes. This has led to an overall fall in production of other cereals by roughly 53 million tonnes which can be taken as an estimate of the demand outstripping supply and thereby can account for half of excess demand in the world food market. And the demand for food grain is likely to remain high because in the short run, ethanol is the only alternative bio-fuel in the picture. Even Hilary Clinton and John McCain have changed their minds from anti-ethanol subsidies to pro-ethanol ones.

The supply side has also to be looked at to analyze this reason for agflation in greater detail. The supply of food grains is not likely to raise much because land for cultivation and technology used are sticky in the short run in terms of their development. Also, global warming is predicted to cut off farm production by a sixth by 2020. Also, rising oil prices might reduce the use of oil based fertilizers. International Food Policy Research Institute (IFPRI) believes that food prices will rise by between 10% – 20% by 2015 because of demand keeping ahead of supplies.

This is a break from the past where food prices were declining and it marks the end of cheap food. Agflation can have important consequences on the world standards of living. There will be gainers and losers. The gain from rising prices will go to farmers and, hence, increase their wealth but only if the government allows them to keep the gains. Food exporting countries like India, South Africa and Switzerland will gain from the increased export earnings. Inequality between rural and urban incomes will also be bridged to a certain extent with rising incomes of the countryside. But along with stating the positive effects of rising prices, other realities also need to be brought into focus. There could be a large number people who could be worse off due to rising food bill one step ahead of rising incomes in the rural areas. Rising prices will also hurt the vulnerable group in cities. According to Gary Becker, a Nobel economics laureate, if food prices rise by one-third, they will reduce living standards in rich countries by about 3%, but in very poor ones by over 20% as the very poor ones have a greater component of agricultural contribution to GDP as compared to the rich ones. In poor countries also, the poor, both the landless labourers and the urban poor will be affected to a greater extent. This reflection raises welfare concerns and requires governments to take measured action instead of politicking. Agflation has another remarkable effect – it contributes to accelerating inflation but in different proportions in different countries. The central banks of developing countries have responded to this by adopting tight monetary policy and hence raising interest rates; while surprisingly the developed nations have decreased their interest rates (the Federal Reserve reduced rates by 50 basis points in September and 25 basis points in October and the Bank of Canada had cut rates in the first week of December). This was done as agflation doesn’t contribute to inflation much, agricultural production and consumption being a small part of the GDP. Hence, the rising interest differential will encourage capital flows into developing nations with emerging markets supplementing the change in equation of power balance. This is already happening as the American and European economies are slowing down while China and India are growing in leaps and bounds. But a lot depends on the economic policies followed by the countries and this might just be a bubble in the emerging markets of the developing nations.

Himadri Agarwal