Food prices: The grain of truth

Food prices have risen sharply in 2008. Why?

©Carlos Barria/Reuters

Over the last two years, prices of agricultural commodities have risen spectacularly, and nominal prices for many crops and dairy products are at an all-time record high. This surge in prices is not unique, and when adjusted for inflation, the recent price spike is neither unique nor the biggest one to occur in the last three decades or so.

But after a long period of rapidly declining real food prices, it has taken analysts, policymakers and the wider public by surprise. Moreover, coming against a backdrop of other global worries, the latest food price rises were bound to cause some anxiety.

In light of recent unrest across the developing world, many poorer people are worried about food becoming less affordable. But even in OECD countries, from the US to Europe through Asia-Pacific, people have winced at the rising cost of their food basket. Some increases we have been expecting, such as fish because of dwindling resources and rising demand, but now prices for basic items like cereals, milk and meat are rising too.

Why is this? A first simple answer is short-term shifts in the market. Farm produce markets are notoriously unstable as climate, disease and other natural factors affect output. Agricultural trade is generally only a small share of global production and consumption, so small changes in domestic supply or demand can have large impacts on the volume of trade, which in turn leads to wide price swings.

This is what has happened in world grain markets since 2005. First, supply has been squeezed by disappointing harvests, notably in Australia, Canada and the European Union. Though there were increases elsewhere, notably in the United States, global production of wheat and coarse grains were only 3% higher in 2007 than two years before. This was not enough to satisfy an increase in the total use of these grains for food, feed and biofuel production, by 5% over the same period.

Moreover, reserves had already been falling as a result of reductions in public stockholding in both OECD and non-OECD countries, and they kept declining from 2005 to 2007 as world use exceeded supply. So cereal stocks-to-use ratios have been low and since the late 1990s they fell from 35% to under 20% for wheat and from around 30% to less than 15% for coarse grains. Little wonder there was a surge in prices.

Rising maize prices from 2004-05 onwards drew producers away from oilseed production, causing oilseeds prices to rise as well.

Dairy markets tell a similar story. With tighter supplies, and with dairy trade an even smaller fraction of global production and consumption than cereals, only very small changes in export availabilities are needed to jack up dairy prices. The EU is a case in point, where limited output growth and strong demand combined to clear intervention stocks and squeeze the quantities available for export. Add to this a drought in Australia, shifts in land use in Argentina away from dairy farming, and strong demand in many emerging and developing countries, and it becomes easier to see how the world market should become more fraught.

The farming adage that the best cure for high prices is high prices could prove pertinent. With a return to more “normal” climatic conditions, global supplies are expected to increase anew and world prices will ease down. Nevertheless, there are other factors of a more permanent nature at play that should keep average prices relatively firm..

Rapid income growth and dietary changes are one, in particular in Asian developing countries, where demand for protein-rich products is rising. That means more meat, and more feedstuffs needed to raise farm animals. While much of these growing needs will be domestically produced, most of the future growth in world imports of most agricultural commodities is expected to take place in non-OECD countries.

The weak dollar is another factor at play. Normally, higher prices would incite farmers to raise output, but price signals have been dulled by a weaker US dollar. As global commodity prices are set in US dollars, exporters of farm produce in many countries have not seen the same price increases in domestic currency terms as has occurred in world markets. Their supply response has been slower than what it otherwise might have been with a stronger dollar, while strong currencies in importing countries have in turn fuelled demand. Energy costs are also a major element to consider. The OECD assumes high petroleum prices will continue over the medium term, which will further affect capacity to adjust agricultural supply to meet higher world demand, and put further upward pressure on market prices.

click here for larger graph

Then there is the much discussed role of demand for biofuels, which is diverting land and feedstocks away from food. The latest OECD projections suggest a doubling in world ethanol and biodiesel production over the next 10 years. This demand will absorb 36% of US maize production and 64% of sugar cane output in Brazil and approximately 40% of vegetable oil consumption in the EU and nearly 60% in Australia by the year 2017.

So, even if climatic growing conditions improve, these underlying factors will keep average prices firmer than they have been for some time, but not as high as they are at present. At first, benefits will flow to cereals and oilseeds producers while livestock producers will initially only face higher input costs. But with a lag, these increased costs will translate into higher market prices as well. Comparing the average of forecast prices over the next 10 years with that of the previous decade, the latest OECD projections indicate price increases of about 20% for beef and pig meat to around 50% for cereals and over 60% for butter and oilseeds.

Probably about one third of the projected increase in average cereal and oilseed prices over the next 10 years can be explained by increased demand for feedstocks to satisfy growing biofuel production. In addition, with growing demand for agricultural commodities other than for food as incomes grow, the volatility of agricultural product prices may well increase as well.

New breed of investors
One perhaps under-researched but highly reported factor behind food price rises is the emergence of non-traditional traders in commodity markets. Movements in agricultural markets are not correlated to fluctuations in stock markets and with financial products becoming very sophisticated, investors have started using these markets much more than before, either for speculative reasons or to seek portfolio diversification. Global trading activity in futures and options in agricultural derivatives markets has more than doubled in the last five years and increased by 30% in the first nine months of 2007. Data for the US show that in the three years from February 2005, the total open contracts in maize, wheat and soybean futures more than doubled. At the same time, the share of contracts bought by financial funds and other investors has increased from below 20% to well over 40% for maize and oilseeds.

This surge of new investment in futures commodity markets affects prices in the short term. Over a longer-term period these may prove temporary, particularly as funds can move rapidly in and out of commodity markets as profit opportunities evolve. Still, given their size, this may well affect future price volatility.

What does this mean for food prices and general inflation? To start with, there is a difference between prices for agricultural commodities and the retail price of food. In OECD countries, farmgate prices account on average for 25% of prices at the retail level. Retail prices are influenced by a host of factors along the supply chain-energy, transport and wage costs, the extent of market competition, and so on.

With the share of the food component in the consumer price index ranging between 10 to 20% for the majority of OECD countries, the weight of food prices on overall inflation rates is not negligible. In 17 out of 30 OECD countries the somewhat spectacular increases in retail food prices in the past year has contributed less than 0.5 percentage points to overall changes in inflation, but between 0.5 and 1 percentage point in eight countries and over 1 percentage point in the remaining five.

For developing economies the impacts are much bigger and the contribution of food price inflation to the consumer price index has been as little as 2 percentage points in India and Peru to as much as 9 points in Bangladesh, 12 points in Kenya and 16 in Sri Lanka. Commercial producers in these countries are likely to profit from higher prices, as will many employees and local economies. But it is the urban poor, particularly in the net food importing developing countries such as Bangladesh, Egypt, Nigeria or Haiti, who will feel the brunt, as an even higher share of their already limited incomes will have to be spent on food.

In the short term, humanitarian aid will be needed, as the numbers of people suffering from extreme hunger has further increased. However, the medium-term focus should be on policies that foster growth and development, to lift purchasing power of the poor. Agricultural trade policies also require further reform as trade restricting practices-whether they restrain exports or imports-have undesirable and often unintended impacts.

On the supply side, the link between production and yield shortfalls and climate change might be further explored as should the possibilities for further agricultural productivity growth. The merits of every initiative must be explored, from ideas like improving agricultural productivity in general and storage facilities in particular in developing countries, to building the infrastructure required to link farmers in these countries to other markets. Also, we need a dispassionate look at how genetic modification might affordably and acceptably improve yields, crop resistance to drought and boost development. On the demand side, the largely policy-driven biofuels warrant a close review, not least in light of their questionable economic and environmental effectiveness.


References

  • OECD (2008), “Rising Food Prices: Causes and Consequences”, working document, Paris.

©OECD Observer No 267 May-June 2008




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