Central bank’s tools cannot fix food inflation

As agricultural commodity prices continue to rise – with corn matching on Monday the record set during the 2008 food crisis – central bankers face an uncomfortable choice: to tighten monetary policy in response to food and energy inflation or to bank on the surge being just a temporary problem and focus on much lower core inflation.

The dichotomy will be at the centre of the discussions of the European Central Bank and the Bank of England this week. Their response, together with banks such as the Federal Reserve and the People’s Bank of China, will shape the macroeconomic impact of the current rally in commodities markets.

The International Monetary Fund has just weighed in on the debate, publishing last week a research paper by one of its economists that argues that central bankers need to take very seriously food inflation and recommends, in some cases, “stronger policy action” – jargon for higher interest rates.

The paper – Reconsidering the Role of Food Prices in Inflation by James P. Walsh – says that the experiences of 2003-07 suggest that the transmission of food inflation into the overall rate of inflation is strong. Moreover, food inflation is not a temporary phenomenon but, in many cases, is persistent.

“For policymakers in many countries, food inflation is therefore not something that can be broadly disregarded as a phenomenon only tenuously linked to underlying medium-term inflation developments,” the paper states. “Eliminating food prices from core inflation may provide an incorrect picture of underlying inflation trends, especially in low income countries,” it adds.

Central bankers are in uncharted waters: the last time they dealt with a price shock in agricultural commodities of similar breadth and intensity was in 1972-74.

The arguments in favour of stronger monetary policy are compelling, but the paper fails in one crucial aspect: what can central banks do against food inflation? In truth, nothing. Short of cultivating crops in their own backyards, policymakers are not able to increase the supply of agricultural commodities, which depends largely on favourable weather.

Meanwhile, they can only modify demand at the cost of sinking the rest of the economy into recession. Food demand is largely inelastic: consumers do often trade down, moving to cheaper food, but that affects only quality, not quantity.

As such, the fight against food inflation will require other measures away from a central bank’s common toolbox. The problem is largely in the hands of governments, which can take some basic measures. They can step away from export restrictions, cut market-distorting subsidies, discontinue deplorable ethanol policies and reverse decades-long budgetary cuts in agriculture research, development and infrastructure investment. But politicians are mostly interested in finding someone to blame, particularly speculators.

More than five years into the food price rally, the G8 and the G20 have yet to show the political courage to resolve the problem and reform agriculture. This is why food prices are so sticky and filter down to the rest of the economy. So the ball is in the court of the ECB, the Fed, the PBoC and the BoE. For the world’s central bankers, former US Treasury secretary John Connally puts the problem in a nutshell: “Our agricultural policies but your food inflation problem”.