Has the sun set on cheap, plentiful oil? <br>Photo by <a href="http://flickr.com/photos/ccgd/226344463/">Calum Davidson</a> (<a href="http://creativecommons.org/licenses/by-nd/2.0/deed.en">CC</a>).
Has the sun set on cheap, plentiful oil?
Photo by Calum Davidson (CC).

Policy Innovations Digital Magazine (2006-2016): Briefings: Inflation Fuels Global Hunger

Nov 9, 2007

Most economists will tell you inflation is like red wine: a little is good for you, but too much can lead to confusion and paralysis. And both can put a dent in your wallet.

Despite the best efforts of central bankers everywhere, inflation is making a comeback. 1,500 retirees recently took to the streets of St. Petersburg, Russia to protest the effect that rising prices have had on the purchasing power of their pensions. Earlier this year, thousands of Mexicans demonstrated after a 400 percent rise in the price of corn flour in just three months. Even markets for luxury goods such as fine red wines have seen prices double and triple.

Beating back inflation has been a core macroeconomic goal for Western policy makers since the disastrous stagflation era of the 1970s. Inflation distorts price signals, erodes savings, and discourages private investment.

So if everyone is so intent on minimizing inflation, what is behind its sudden resurgence?

A number of geopolitical and economic conditions have impacted supply and demand of energy, grains, and metals. Consumption growth in emerging economies like China and India has driven up demand for base metals and grain products. Oil demand is increasing among the world's largest economies. The surging biofuels industry, led by Brazil, China, and the United States, has upped demand for various grains, especially corn, and diverted farmers' attention away from other crops. And with commodities mostly traded in U.S. currency, the declining dollar has further increased demand from countries with stronger currencies.

While droughts in major grain-producing countries and turmoil in the Middle East are short-term supply issues, fears remain that the current increase in prices is different and longer term than past commodities crises. "This is the world's first demand-led energy shock," Lawrence Goldstein, an economist at the Energy Policy Research Foundation, told the New York Times this week. Corrections in the near future will likely be overshadowed by continued increasing demand from developing countries as hundreds of millions in India and China climb out of poverty with disposable income in hand.

Rising prices have generated significant investment and speculative trading in the commodities sector in both futures and physicals. Commodities are seen as a hedge against the declining dollar and potential losses in other sectors, such as real estate. Banks and securities firms, including JPMorgan Chase & Co. and Lehman Brothers Holdings Inc., have increased their hiring of commodities traders by 33 percent in the past year, as reported by Bloomberg News.

Even Islamic banks have pounced on the sector, with Malayan Banking Bhd launching a shariah-compliant fund to invest in copper futures on the London Metal Exchange and wheat futures on the Chicago Board of Trade.

The current commodities boom may yield markets and higher crop prices for some farmers, but not everyone is reaping from these trends. The poor have less money to save or invest in assets and are therefore less insulated from inflation's negative impacts. As the prices of commodities rise, food prices are driven up by increased costs for petroleum-based fertilizers, plastic packaging, transportation, and livestock feed.

For the billions of people living on less than $2 per day, many of whom are subsistence farmers or landless laborers, higher prices for staple foods have devastating consequences.

With food prices in the United States rising at the fastest pace in 17 years, the biggest losers are developing nations. The United States is the world's leading food aid donor, but this year aid was cut to less than half of what it was in 2000. Director-General Jacques Diouf of the United Nations Food and Agriculture Organization cautioned that soaring food prices could make it harder for the international community to meet the Millennium Development Goals of halving extreme poverty and hunger by 2015.

According to the U.S. Department of Agriculture, the average consumer in the United States spends just over 6 percent of disposable income on groceries, and thus is moderately affected by the recent price increases. The story is quite different for people in the developing world where these figures are significantly higher. Food expenditures in the home account for roughly 39 percent of disposable income in India and nearly 50 percent in Indonesia. When food prices skyrocketed in China in August, the country's overall inflation rose to a level not seen in more than 10 years.

A big concern is that rising food prices will cause civil unrest. In addition to Russia and Mexico, there have been uprisings in Yemen and some African countries. The International Monetary Fund recently reported that inequality has been on the rise in most regions of the globe for the past two decades. Higher food prices will exacerbate growing domestic inequalities and could further provoke the already oppressed poor.

China has sought to mitigate inflation by increasing interest rates five times this year already and freezing prices on some consumer goods. The government has also been encouraging minimum wage increases, which have gone into effect in many cities, including Beijing, Shanghai, and Shenzhen.

Some argue that the Chinese government should allow the renminbi to appreciate at a faster rate in order to reduce the prices of imported food.

It's not just food prices that are pinching the developing world. Many developing economies have emerged as manufacturing powerhouses, with increased dependence on imported coal and oil. Meanwhile, as developed countries have switched from a manufacturing base to a primarily services-driven economy and increased their energy efficiency, the correlation between economic performance and oil prices has decreased significantly.

Overall, these conditions are reminiscent of the 1970s, when a weak dollar and high oil and gold prices led to severe global inflation and hit the United States especially hard. The United States and other developed nations may not be insulated from today's inflation for long. As the cost of manufacturing goods increases and developing countries struggle to allay public anxiety over fast-rising food prices, some economists believe that inflation, particularly in China, will be exported to the rest of the world.

Others have their doubts, citing increased labor productivity and a large rural population that will be attracted to low-paying factory jobs.

Many European manufacturers have been reluctant to raise prices on certain goods to avoid losing market share due to the size and profitability of the U.S. market. Yet lately they've had no choice, and it's the wealthy that are feeling those effects. The prices of German luxury cars, Italian furniture, and designer suits are rising at double-digit percentages. This is mostly due to the euro's strength against the dollar and the growing number of U.S.-dollar billionaires in the world, which is up 15 percent from last year. A growing pool of money is chasing an often finite amount of luxury goods. Retailers that have previously absorbed costs by shifting production to Asian countries with lower labor costs and signing currency-hedging contracts now acknowledge that those measures won't work for long.

Time will tell whether these trends have universal impact, or simply bring us to new levels of global inequality.

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