Business Times 2 May 08;
Wage-price spiral is now a real threat, reports CONRAD TAN
FOR governments and central banks around the world, the recent jump in food prices is posing an unpleasant and unusual dilemma.
The last thing most central bankers want to do is to put the brakes on economic growth by raising interest rates or otherwise tightening the supply of money. But if they don't, rising food prices threaten to push overall price inflation so high that expectations of a prolonged period of inflation could fuel a vicious circle of wage and price increases that could spin out of control.
Governments are under 'great pressure' to deal with rising food prices 'and that is going to have some impact on macroeconomic stability and management', said Subir Gokarn, chief economist for Asia-Pacific at rating agency Standard & Poor's, earlier this week.
Many governments are reacting to the shock of higher food prices by imposing restrictions or outright bans on the export of food items, and using price caps or subsidies to cushion the impact of higher prices on their people. Unfortunately, such measures are likely to make the problem worse, and last longer, say economists.
Paul Schulte, chief regional equity strategist for Asia ex-Japan at Lehman Brothers, thinks that food prices have been unusually low for the past three decades. He strongly believes that the sudden supply shortage is due to chronic underinvestment in agricultural technology and land over the past three decades.
'We are just coming out of a 30-year depression in agricultural prices. So it's not that agricultural prices are too high, it's that they were too low.
'In real terms - that is, adjusted for inflation - even with these price increases, prices are still below where they were in 1975.
'All over the region, you look at how much money has been spent on investing in agriculture - and it has collapsed. The result is agricultural yields in Asia that have gone from 3.5 per cent in the mid-1970s down to less than one per cent now - a 60 per cent reduction in output.'
Glenn Maguire, Societe Generale's Asia chief economist, believes central banks would do well to distinguish between overall inflation and 'core' inflation, which excludes food and energy prices. 'Food inflation is lifting headline rates of inflation. However, as there is less income left for other areas of expenditure, non-food prices should fall,' he said in a report on April 17.
But 'though core inflation rates may be falling, food-driven rises in headline inflation will be reflecting rising social inequality and growing risks of social unrest', he added.
'As such a high proportion of income in emerging economies is devoted to food consumption, the risk is that food inflation sparks higher inflation expectations. Higher food prices could therefore lead to higher core inflation in the future.'
HSBC's Asian economics and strategy team said in a report on April 15: 'What matters above all for sound monetary policy is the anchoring of inflation expectations.'
Although raising interest rates or allowing faster currency appreciation will not produce more food, tighter monetary policy can help to drive down prices of other goods and services, and prevent the so-called 'wage-price spiral' of inflation, where workers demand higher pay to cope with rising prices, which then drives business costs up so that prices of goods and services rise even further, exacerbating the problem.
'The risk that rising food prices will trigger powerful second-round effects is already becoming apparent. In the Philippines, the government recently proposed a hefty round of public wage increases to cushion the blow to civil servants,' said the HSBC analysts. Excessive liquidity is also starting to affect overall price levels, they said.
Allowing local currencies to strengthen is a 'more equitable' response than raising interest rates, said Mr Maguire. 'The notion that consumers need to be penalised by higher interest rates so they will eat less and, therefore, reduce food inflation is a perverse one.'
Many economists believe that food prices will stay high for some time to come. But not everyone is convinced that food prices will continue to rise rapidly, at least in developed countries.
Paul Donovan, deputy head of global economics at UBS, believes that food price inflation in large, developed countries is likely to slow later this year as economic growth wanes. This is because labour costs, which account for the bulk of food costs there, are expected to fall.
But this will come as cold comfort to the rest of the world, where raw agricultural commodity costs make up a much higher proportion of the price of food.
And while Lehman's Mr Schulte believes that sovereign wealth funds have the money to invest, he is not optimistic that countries will readily open their doors to new agricultural investment by such funds.
'Food is the ultimate national security issue. Countries always will be very touchy about their food supply. That's why every country thinks that self-sufficiency makes the ultimate sense. In many cases, self-sufficiency is an illusion, because some of the inputs into food production are imported.'
