2 nasty shocks could bring more inflation sooner rather than laterInflation is coming down nicely… but will it last?
The latest inflation figures out in the U.S. on 12th July 2023 that saw the headline rate fall from 4% to just under 3% have sparked somewhat of a celebratory mood at investment banks, hedge funds and amongst economists. Stock markets have continued their upward momentum, spearheaded by excitement in A.I tech and the productivity gains it promises added to better forecasts for corporate earnings for the second half of the year. All this is underpinned by the prevailing belief that inflation will come down quickly in much of the developed world in the next 6 months. Even reaching the Federal Reserve target in the 2% target in the U.S. within that period. Indeed some are even warning that the Fed might be in danger of overreach with an interest rate regime that history will deem to have been too aggressive.
Much of the data does indeed point to a downward trajectory for prices in the near term. But as I argued in a recent piece, the bigger picture might be very different for the rest of the decade, with underlying structural changes on the supply-side creating chronic upside pressure:
But even in the immediate future, there are two big shadows lurking that might soon come to the fore and exacerbate inflation and the cost-of-living crisis, and add more pressure to an already weakening economic environment.
First it is important to understand that the lull in recent inflation has almost entirely been driven by lower food and energy prices. Both have eased considerably since the highs reached following Russia’s invasion of Ukraine last February 2022. Wheat prices are down 56% since then, while energy prices have fallen by 16.7% over the last year, oil prices on their own have fallen even further by 26.5%. These falls are projected to persist into the second half of the year, especially as the Chinese economy has a disproportionate influence on commodity and energy prices, given the extraordinary volumes they import, and is expected to keep on its disinflationary path for the time being after a promising start to the year.
The most immediate threat to the rosy outlook for inflation is the Grain Deal between Ukraine and Russia. This kept corn and wheat flowing from Ukraine through a narrow corridor in the Black Sea. Almost 32 million tonnes have been exported since the deal started end-July last year. This looks set to expire as of tomorrow, Monday, July 17th. While this is the lesser of the two looming problems for immediate inflation concerns and has largely been factored into food prices, it will still have a measure of an impact and will almost certainly sow seeds of volatility, making prices more susceptible to future shocks; Of which the second far more pressing issue – that of the onset of the El Nino weather pattern – may then have far worse consequences.
To be certain, the grain deal is already moribund in many ways with under 30 vessels passing through the corridor a month in June 2023 from a high of 176 last September. Ukrainian grain exports have already halved since the start of the war and the country’s share of global wheat exports now only makes up 5% of the total. Grain prices have actually been kept low mostly by Russia’s own recent bumper harvest and its large inventory of wheat. Russia has set demands that are unlikely to be met given the current geopolitical climate; Such as allowing its state agricultural bank to be reconnected to the SWIFT system (that smooths cross-border payments in hard currency) and the reopening of an ammonia pipeline to one of the Ukrainian ports it occupies. But, while their demands are aggressive but not unreasonable, it probably also has other more cynical motives too for ending the grain deal that will make it harder to revive.
Even though Russia makes only around USD$10 billion a year from its wheat exports, a meager amount compared to its energy exports, it deeply understands wheat’s geopolitical impact. By ending the grain deal, Russia may in fact be trying to put pressure firstly and more obviously on Ukraine’s revenue streams, but more importantly, bring the matter into focus on the international stage, especially amongst its friends in the Global South to ratchet up denunciations of the war or at the very least make sure they keep turning the proverbial blind eye to it in exchange for below-market-price wheat.
Russia has in fact been flexing its muscle in the wheat market since the start of the year. Its agriculture ministry has been rejecting deals that fall below a set price level. It has been attempting to maintain a minimum price of USD$240 per metric tonne in June. It also started bombing Ukrainian grain facilities at one of the open ports under the grain deal, Odesa, further hampering Ukraine’s ability to export under the terms of the deal. Whether Russia can influence global prices may be moot. Its “minimum price” for wheat had to fall from USD$270 in March after prices, in particular in Europe, fell considerably. But combined with the effect El Nino will have on agriculture, Russia may yet get its way.
Speaking of, the onset of the weather pattern has historically been a mixed bag for grain yields in general, and therefore prices. In 2006 and 2009 for example, there were historically high yields of wheat in the U.S. But 2002 – also the beginning of an El Nino year – yields were the lowest for that decade. Stock markets have not yet factored in the turmoil in agriculture that El Nino may cause and by extension, food prices as a whole. Given its unpredictable nature, that is understandable. This El Nino though already looks ominous, exacerbated by the effects of human-made increases in CO2. As has been widely reported, we may collectively breach the U.N target of 1.5C above pre-industrial levels in the coming year, even for only while the weather pattern lasts for now. Even though El Nino hasn’t even really begun, we have already had biblical flooding in India, Japan, and South Korea while temperatures in the Mediterranean have soared ever-closer to the never-before-reached 50C mark and is also at record levels in swathes of the U.S.
And it’s only July.
Already though Australian wheat yields – a producer of note – have been forecast to drop by a whopping 34%. And in the U.S. – the joint third largest – wheat yields will be at an 8-year low this coming December according to the United States Department of Agriculture (USDA). And, as I’ve said, that’s before the real impact of this year’s unprecedented onset of El Nino has been fully understood and felt.
El Nino also has a knock-on effect on the energy sector. It usually brings with it extreme cold to northern Europe and high rainfalls to the continent’s south in winter. While many have heralded the energy crisis that immediately beset Europe in the aftermath of the Russian invasion, at an end. But that may prove too soon. None other than the head of the IEA (International Energy Agency, a global body that provides research and gives advice to governments) warns against complacency this coming winter when prices may yet again spike in the face of severe weather.
And it is not only in Europe. Recent episodes of El Nino have brought flooding to Chile’s copper-rich north that saw global prices quickly spike as a result. Flooding in Peruvian mines lead to spikes in zinc prices. And in Indonesia, a top nickel and copper exporter, a severe drought meant that hydroelectric power struggled to provide sufficient electricity to its mines.
The damage wrought by this El Nino could be truly immense and with it will come damage that will take a lot of funds to restore. A U.S. Journal of Science report found that the damage brought on by the 1997-1998 period – widely deemed to be one of the worst on record – was about USD$5.7 trillion. And the effects are felt for years to come. A Dartmouth Research paper forecast damage to the tune of USD$3 trillion for this El Nino, right up to 2029. Money that stretched public and private finances can ill-afford right now. And indirectly lead to higher inflation, by “crowding out” investment that is more productive and increasing debt piles and therefore the scarcity of money itself (which leads to higher interest rates).
What is certain is that this El Nino is more than likely to have a severe impact on prices for years to come. And what seems like a lull between now and the end of the year in food and energy prices may yet prove to be the calm before the proverbial storm. Modeling by Bloomberg Economics published end-June found that previous episodes of the weather phenomenon added nearly 4 percentage points to non-energy commodity prices and as much as 5.5% to oil; Oil prices that will also face upward pressure as investment falls in an asset that will increasingly be considered a stranded one, as the green economy takes over in the coming decade.
For some countries, the effects of the mayhem that may come to pass in agriculture and energy will be felt much more. Especially in emerging and developing economies where food makes up around a third of all consumption. But even in developed countries such as the U.K. that rely heavily on imports for its food and energy – the third largest importer of food and drink behind China and Japan in fact – and where price sensitivity to external shocks is felt more than in most of its peers – the effects there are also likely to be acutely felt.
As markets dance on their merry insouciant way to new record highs. Safe in the knowledge that inflation has been decisively brought under control and interest rates likely to come down fast with it. They may want to just check themselves (and their stock options) for a second or two. The end they proclaim may be another false dawn in what is shaping up to be a relentless decade of shocks and upsets.