Food inflation report 07/08

A synopsis of the report titled:  “Back to the ‘70s?”

How Higher Commodity Prices are leading to the return of Food Price Inflation

Key Findings

1. Food inflation has been benign for the past 25 years but is poised to rise during the next five years.

2. This parallels the experience of the1970s when surging commodity prices led to food inflation rising by more than eight percent.

3. Major commodity food inputs (such as corn, wheat soyoil and milk) have been driven sharply higher as a result of increased global demand for food, but also due to a sharp increase in the use of corn for the production of ethanol.

4. During the next five years, food inflation is forecast to increase by an average of 7.5 percent, well above the 2.3 percent average of the past 10 years.

5. The price of major commodity food inputs are already well on their way to a new plateau, 50‐80 percent above levels seen during the past 25 years. However, with any weather disruptions, commodity prices have the potential to rise by an additional 50 percent, resulting in even higher rates of food inflation in the coming years.

Food price inflation, which has been benign for the last 25 years, increased sharply in 2007, and will likely continue to increase over the next five years. It is a situation reminiscent of the 1970s. Like then, the prices of key commodities have begun to move to a new plateau. This time the price movement is largely led by increased corn demand for ethanol.

To put this in perspective, for the past 25 years food price inflation has been limited at both the consumer and wholesale levels. What increases in commodity prices that did occur were short‐term and were willingly absorbed by manufacturers and restaurants in a bid prevent losses in market share.

The trend of low food price inflation and short‐term commodity price increases was broken in 2007. The CPI‐Food rose at an annual rate of 5.4 percent during the first ten months of 2007, a level not seen since 1980. The overall rise in food input costs is likely to make 2007 the first of a multi‐year period of higher rates of inflation for food manufacturers, grocery stores, restaurants, and consumers. In response to rising food input prices, the U.S. food industry is beginning to pass its increased costs to consumers by raising prices.

Global economic growth has increased demand for grains and oilseeds, while the sharp decline in the value of the U.S. dollar has been supportive to commodity prices in general. However, the primary catalyst for the rise in the price of corn (as well as other food inputs) has been ethanol production. Corn used for ethanol Study Synopsis/The Return of Food Price Inflation in the U.S. has doubled during the past two years, and now accounts for 25 percent of total corn utilization.

The surge in the use of corn to produce fuel led to a 20 percent increase in the number of corn acres in 2007 and created what is likely an on‐going “acreage battle” in the coming years. This environment has led to reduced stocks of all grains and, consequently, not only higher but much more volatile prices.

Higher corn prices also translate to higher prices for products derived from animals whose primary feed is corn.

The U.S. experienced a similar period of rising commodity prices and food inflation in the 1970s. Commodity prices doubled during the early 1970s, and this ultimately resulted in food price inflation from 1972 to 1981 averaging 8.2 percent. Underlying the rise in commodity prices was a confluence of global macro‐economic factors. The recent run‐up in commodity prices, similar to the experience of the early 1970s, is a good indicator of what can be expected in the next five years in food price inflation.

The price of commodities such as corn, wheat, soyoil and milk, have already begun to permanently move to a new plateau, due to the aforementioned broad‐based macro‐economic factors. The increase in prices will be passed on to consumers, and, therefore, are expected to result in consumer food inflation rising to an average of 7.5 percent during 2008‐12.

Much as experienced during the 1970s, food price inflation rates are moving higher during the next five years as a result of sharply higher commodity input prices. While the precise yearly levels of food inflation are difficult to predict, increased commodity prices clearly suggest that food prices will be rising more dramatically during the next five years.

The strong demand for corn is likely to continue and, as a result, corn prices are likely to remain well above previous “normal” levels in the coming years. During 2008‐12, corn futures prices are forecast to average $4.00, 60 percent above the 2002‐06 average.

The price of corn will directly impact nearly all other food input prices during the next five years. Competition for a limited amount of acreage will result in other grain and oilseed prices rising along with corn. During 2008‐12, wheat prices are forecast to average $6.50 per bushel, soybeans $10 per bushel, and rice $10/hundredweight.

The other significant impact of increased corn prices is on the livestock sector. Corn is the primary feed source – among major sources of energy in feed rations, corn accounts for about 85 percent of the total utilized to produce beef, pork, poultry, dairy products, and eggs. Since corn typically represents a large share of the total cost of production, livestock output tends to (over time) respond to rising or declining corn prices. It is not possible to have a dramatic increase in the cost of corn without eventually impacting livestock margins, production and ultimately livestock prices.

For dairy, protein, and egg markets, the price patterns are expected to be responsive to the higher feed costs, but the timing and extent of producers’ response to higher feed costs is less clear. The longer cycles of expansion and contraction for dairy, protein, and egg producers will likely create more volatility in producers’ margins, but ultimately prices will move higher to compensate for increases in feed costs. This includes significant increases in prices (vs. 2002‐06) for pork (+69 percent), chicken (+64 percent), eggs (+58 percent), milk (+43 percent) and beef (+43 percent). Study Synopsis/The Return of Food Price Inflation
 

Weather events are key price drivers for agricultural commodities, and a yield‐related crop shortfall of 10 percent or more in any year would drive prices at least 50 percent or more above the projected average levels. Yields for major crops have been 10 percent or more below trend roughly one in four years (23 percent of the time). With U.S. and world stocks already at minimal levels, such an event would have a dramatic impact upon commodity prices and ultimately upon consumer food prices. While it is hard to predict the impact of weather events, it is likely that the end result would be consumer food inflation rates of close to 10 percent for one or more years.

The impact of rising food input costs will vary dramatically across the different products consumed. Items with limited “value added” (such as livestock and dairy items) will see a much greater impact from higher corn prices, while items with more “value added” (such as bread or cereal) will to see a more limited impact from higher food input costs.

The higher price of inputs, as well as increases due to non‐commodity related factors, will ultimately be passed on to consumers. Based upon the higher food input prices, food inflation at the consumer level will accelerate to an average of 7.5 percent during 2008‐12. This compares to an average rate of consumer food inflation of 2.4 percent during 2002‐06, and an annualized increase of 5.4 percent during 2007.

The wholesale cost of food (PPI‐Food) has historically risen at a rate modestly slower (0.5‐1.0 percent) than consumer food prices, and has been much more volatile. During 2007, wholesale food costs have risen more sharply than consumer food prices (7.3 percent vs. 5.4 percent), and consequently narrowing margins. As wholesale food prices continue to rise, pressure will mount for participants in the U.S. food industry to increase prices at the consumer level in order to maintain traditional margin levels. Over the next five years, higher commodity prices are likely to result in high levels of volatility in the PPI‐Food, but with the overall rate of increase will probably match the forecast increase of 7.5 percent during 2008‐12.

While an overall rate of food inflation of 7.5 percent is forecast for 2008‐12, price increases for different foods will vary significantly. This reflects different levels of increase in the price of the underlying food inputs, as well as how closely the input costs are tied to the consumer price. Consumer prices for proteins and dairy prices are expected to increase by an annual rate of more than 8 percent during 2008‐12, while the consumer price of eggs is expected rise by an average of 13.4 percent.

Much as was observed during the 1970s, food inflation rates are moving higher during the next five years as a result of sharply higher commodity input prices. While the precise yearly levels of food inflation are difficult to predict, the rising commodity prices clearly imply that food prices will be rising more dramatically during the next five years.