Analysis: Drought to cause food price spike but not inflation

WASHINGTON Tue Jul 24, 2012 2:22am IST

Corn plants struggle to survive in a drought-stricken farm field near Evansville, Indiana, July 18, 2012. REUTERS/John Sommers II

Corn plants struggle to survive in a drought-stricken farm field near Evansville, Indiana, July 18, 2012.

Credit: Reuters/John Sommers II

WASHINGTON (Reuters) - Americans face higher food prices at the supermarket because of a drought this summer, but the increase will not have a lasting impact on inflation or the Federal Reserve's thinking on monetary policy.

Corn and soybean prices on the futures market have surged to record highs amid the worst drought in half a century, with new crop contracts for corn rising 50 percent since early June and soybeans increasing about 35 percent.

"It's kind of like a transitory oil price spike. We get good rains next year and it's gone, it isn't something that the Fed will fight as inflationary," said Diane Swonk, chief economist at Mesirow Financial in Chicago.

"Even though it is inflationary, it would not change monetary policy."

When oil prices spiked early this year, the U.S. central bank viewed the impact on inflation as temporary. Inflation pressures have generally been benign against the backdrop of sluggish domestic and global demand.

The inflation outlook will be one of the key factors that will determine whether the Fed will ease monetary policy further this year to aid the flagging economic recovery.

The Consumer Price Index increased 1.7 percent in June from a year ago, matching May's gain and below the Fed's 2 percent target.

Food prices -- which account for about 14.2 percent of the CPI -- increased 2.7 percent on a year-ago basis, pushed by rises in the cost of fruit and vegetables and meat products.

The latest Reuters survey forecast CPI averaging 2.0 percent in 2012 and 1.9 percent next year.

New-crop soybean and corn contracts for delivery in November and December respectively hit all-time highs last week. Economists said it will take at least six months for the impact to carry through to the supermarket.

"The effects become lagged because food processors have already locked in their commitments with the old crop. They will not be felt so much in 2012 as in the first half of 2013," said Howard Simons, an analyst at Bianco Research in Chicago.

How long that will last depends on the duration of the dry spell that is affecting more than half of the country and what the southern hemisphere crop cycle looks like, Simons said.

The National Oceanic and Atmospheric Administration last week forecast higher-than-average temperatures over the vast majority of the country's 48 states in August, with below-average precipitation for Midwest areas already hit by drought.

The U.S. Agriculture Department will survey fields next month and offer new estimates on the corn and soybean crop yield for this year. They will also provide new estimates for 2013.

AFRICA, ASIA FACE FOOD INFLATION

While economists appear unperturbed by the spike in agricultural prices, the United States is the largest exporter of corn, soybeans and wheat, and that could mean food inflation for some importing countries in Africa and Asia.

Soybean output in leading growers such as Brazil and Argentina has been affected by water shortages, leading to lower global production.

Corn and soybeans are mostly used in animal feeds, production of biodiesel and cooking oil. The drought has also destroyed pastures, which could mean high prices for meat and dairy products.

Prices for fresh fruit and vegetables, already on the increase, could also surge. The cost of agricultural products is rising at a time when gasoline prices at the pump are starting to creep up after recent big declines.

Still, economists do not expect the upswing in commodities to ignite significant inflation pressures, citing chronically weak demand in both the domestic and global economies which make it tough for producers to pass on the increased costs to consumers.

"Consumers will feel the increase as it will be magnified by gasoline prices edging higher, but producers will feel it more because they don't have the power to pass it on to consumers who remain very price-sensitive," said Ryan Sweet, a senior economist at Moody's Analytics in West Chester, Pennsylvania.

General Mills, maker of Cheerios cereal and Pillsbury products, said this month that the corn spike did not change its outlook for commodity inflation or prices.

"Consumers should see generally stable prices," CEO Ken Powell told Reuters in an interview on July 10.

INFLATION EXPECTATIONS SEEN INTACT

While a jump in prices would usually lead households to anticipate further price increases, economists believe inflation expectations will not rise significantly.

"Short-term inflation expectations can fluctuate, but long term they should not be affected by a temporary jump in food prices. A spike in food prices has never dislodged long-term inflation expectations," said Sweet.

Ironically, the drought can push meat prices lower in the short term as the high cost of feeds forces producers to bring livestock to the market earlier than they normally would.

"Feed costs account for about 40 to 50 percent of total costs of production, and when a rancher or poultry producer or dairy producer is faced with higher feed costs it's less profitable to produce that animal," said Joseph Glauber, chief economist at the U.S. Department of Agriculture.

"Often times you will see animals brought to market before they reach full weight. In dire cases, producers will liquidate the entire herd and don't expand as much as they might have."

This suggests consumers could face higher meat prices in the long run because of a shortage of livestock. Hog and cattle contracts set for delivery in mid-2013 have risen in anticipation that producers might face higher feed costs.

According to Glauber, about two-thirds of the hay area was in drought and 73 percent of cattle were located in areas experiencing the dry spell.

(Additional reporting by Martinne Geller; Editing by James Dalgleish)

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