Food for thought: EMD and the threat of inflation

At the start of this year there was a widespread view interest rates in emerging nations, as in the developed world, would remain depressed as monetary authorities allowed their economies to heal from the deep damage wrought by the pandemic.

Just six months later, financial markets have been caught by surprise. As economies re-open, the narrative that inflation will prove transitory is being challenged. But whereas central bankers in the developed world are poised to look through price pressures, their emerging market counterparts are less likely to. The central banks of several countries, among them Brazil, Mexico, the Czech Republic, Hungary and Russia, have already raised rates, with monetary tightening elsewhere seemingly inevitable.

This is thanks to a sharp acceleration in inflation, in turn driven by a surge in the price of various commodities. Energy and food price inflation have been the main culprits. However, while favourable base effects are set to dampen the contribution of energy costs to headline inflation, the same cannot be said for food prices.

Global food prices rose for the twelfth month in a row in May, up nearly 40 per cent year-on-year, according to the United Nations' food price index. Prices spiked 4.8 per cent on the month, the sharpest monthly rise in over a decade.

According to the UN, strong demand for corn in China, an ongoing drought in Brazil and increased global use of vegetable oils, sugar and cereals are some of the factors that have  caused prices to rise rapidly around the globe. It said, for instance, that palm oil prices reached their highest level since February 2011 due to slow production growth in Southeast Asia, with rising global imports keeping inventories low in leading exporting nations.

Food inflation a growing worry

Central banks in emerging markets are, for the most part, mandated with targeting headline inflation. While many believe this spike will be temporary, especially as energy price inflation begins to moderate, the relentless rise in food prices is challenging this narrative. The fact food prices may continue rising for a while longer yet will be a worry to many interest-rate setters. Ongoing supply-side constraints caused by the pandemic add to the likelihood more central banks will turn hawkish, especially in countries that are able to re-open their economies.

Part of the problem is that consumers in poorer countries spend a far higher share of their disposable income on food than their counterparts in richer ones. Typically making up around 25 per cent of the overall spending basket, food will often be the biggest single constituent of consumer price indices.

Since history tells us rising food prices can quickly turn into a potent source of social unrest, central banks that are still keen to support economic recoveries could find themselves in a bind.

Ranking food price vulnerability

To help assess the countries where higher food price inflation is most likely to lead to further monetary tightening, we have constructed a simple matrix.

To gauge a country’s overall vulnerability, we consider five separate inputs. The first and second are the extent to which domestic food prices are correlated to world food prices, and the country’s reliance on food imports, expressed as a percentage of GDP. Central banks in countries that are more self-sufficient and rely less on imports, and where domestic food prices are less correlated with global food prices, will tend to be less concerned.

We also consider the importance of food spending by looking at food’s weighting within each country’s CPI index, the performance of exchange rates (to assess the pass through of global food prices in local currency terms), and assess historic lags between the peak in global and domestic food prices.

The matrix, shown in Figure 1, ranks 24 emerging market countries according to combined scores across each of these measures.

Figure 1: EM food price matrix

Note: Local food inflation peak ranked by number of months separating peaks in local versus global food inflation during previous episodes. Source: Aviva Investors, as of July 2021

Driving monetary policy

There are usually three things a central bank thinks about when setting interest rates: how far inflation is from its target; whether there’s any slack in the economy; and the performance of financial markets, in particular the currency.

However, the scale of the recent rise in prices means food inflation is an unusually important driver of emerging market central bank policy. By giving us greater insight into which countries are most exposed, and the extent to which these forces are likely to intensify or dissipate, this matrix provides a useful starting point in our analysis of the near-term outlook for monetary policy.

It helps us better understand which central banks will be prepared to look through higher inflation and which are likely to feel compelled to ‘get ahead of the curve’ and hike rates to prevent expectations from becoming anchored.

This analysis has a direct impact on investment decisions as well. Despite the high yields on offer, Turkish debt looks less attractive when factoring in the country’s vulnerability to food price inflation and the fact it has long struggled to contain inflation even prior to the recent moves.

Meanwhile, South Africa’s relative insulation from surging global food prices may suggest markets are pricing in an excessively hawkish monetary policy reaction from the central bank. Elsewhere, Mexico’s central bank has acknowledged price pressures are likely to last longer than expected, raising rates in an unexpected move at its last policy meeting.

A factor for fiscal policy?

Investors also need to be on the lookout for the adverse implications of food price inflation for fiscal policy. Subsides and transfer payments are a common response to rising food prices but can be expensive. With the financial positions of most governments already weakened by the pandemic, such payments could quickly lead to concerns about a nation’s creditworthiness. Worse still, other countries, unable to bear the cost of alleviating the pressure on consumers, could quickly find themselves facing social unrest.

So far, many emerging market central banks have been reluctant to raise rates, citing still-large negative output gaps and the ongoing effects of the pandemic on domestic economies. But that may no longer be sustainable as demand-pull inflation increasingly coincides with considerable cost-push pressures from higher food prices.

Just as the Federal Reserve starts sounding more hawkish, emerging market central banks are finding out they cannot afford to be behind the curve – whether inflation ends up proving transitory or not.