MacroScan - World Prices and The Transmission of Inflation

The chances are that people under the age of thirty living in most countries of the world would never have experienced price rises of the extent and rapidity of the past year. Globally, the prices of many basic commodities have not risen faster for around three decades.

Inflation as a feature of capitalist economies was subdued and reined in especially from the early 1980s. This was when monetarist policies were used to great effect to counter the inflationary trends of the 1970s. These policies worked not so much by restricting money supply as was the explicit claim, but rather by destroying the ability of the working classes in the developed countries and commodity producers in the developing world to maintain their income shares, even as profit shares have soared.

Since then, across the world the policy obsession with inflation control has been reinforced by the domination of internationally mobile finance capital, which has viewed the possibility of the re-emergence of inflation with both dread and distaste. In countries like India, where the dominant part of the population receives incomes that are not indexed to inflation, price rises have always been politically fraught. But in other countries where indexation was more widely prevalent, it was really the power of finance that made inflation control such an overweening policy priority.

This made most governments unwilling to use expansionary monetary and fiscal policies even in periods of slump, and unable to use them to reduce the amplitude of business cycles. The important exception has been the United States, which has happily run both government and external deficits in its own growth process, and benefited from the access to imports and external savings that came because of the role of the dollar. The privileged position of the US economy allowed it to attract resources from the rest of the world to pay for its own expansion, but this advantage was not shared even by other developed economies.

So the world economy became used to national macroeconomic policies that were so focussed on being sharply anti-inflationary that they were willing to tolerate higher unemployment as well as levels of economic activity well below potential. These policies also dampened inflationary expectations, and thereby prevented rapid price rises even in periods of relatively sustained growth. Thus, the recent expansion of global capitalism in the past decade, with real world output increasing at an annual rate of around 5 per cent and world trade increasing by around 8 per cent annually, has been marked by low inflation rates of only around 2 per cent per year.

But all this seems to have changed dramatically, especially in the last two years. While primary commodity prices in world trade have been increasing gradually since 2002, there have been significant increases in these since around the middle of 2006. Chart 1 (based on IMF data) indicates these trends for the major commodity categories, providing an index based on US dollar prices. It shows that, except for agricultural raw materials whose prices have increased very little, all the other commodity groups have shown sharp rises in price.
Chart 1 >>

Does It may be imagined that the large price increases in these commodities are more apparent than real because they are denominated in US dollars, and the dollar has depreciated substantially in the past two years. But over the past year the increases have been so marked that they are evident even in other currencies. Thus, while all commodity prices in dollar terms increased by 45 per cent in 2007, they increased by 37 per cent in SDR terms.

The rise in price levels for metals was the earliest in the recent surge, with the weighted average of metal prices increasing sharply from the last quarter of 2005, and almost doubling in the two-year period to February 2008. Global oil prices really began increasing in 2004, as it became evident that the US war aggression in Iraq was unsuccessful in ensuring either peace or stable oil supplies from that country. But subsequently the price has been more volatile, even falling in 2006, and only the past year has witnessed the most rapid price increases for oil since the 1970s. (See related article on oil prices.) In 2007, other energy prices have also soared. Coal prices more than doubled last year, thereby showing a faster rise than even the oil price.

Food prices, like agricultural raw materials, had shown only a modest increase until early 2007. But since then they have zoomed, such that the IMF data show more than 40 per cent increase in world food prices over 2007. The FAO food price index, which includes national prices as well as those in cross-border trade, suggests that the average index for 2007 was nearly 25 per cent above the average for 2006. Apart from sugar, nearly every other food crop has shown very significant increases in price in world trade over 2007, and the latest evidence suggests that this trend has continued and even accelerated in the first few months of 2008.

What explains the recent increase in global commodity prices? It has been argued that this is essentially demand-led, the result of several years of rapid economic growth and the voracious demand from some fast-growing countries such as China in particular. Certainly there is some element of truth in this. And to the extent that this is true, it implies that the world economy is heading back to the old Phillips-curve based scenario, whereby rapid and prolonged growth in a capitalist economy comes up against an inflationary barrier.

For the past two decades and more, international capitalism was able to deal with this and avoid Phillips-curve type outcomes through political economy processes that restrained the wage and income demands of working classes and primary producers. But clearly there are limits to such a process, and these limits are now being reached.

If this were the only cause of the recent commodity price inflation, it would not necessarily be of such concern to policy makers, because it could then be expected that a slowing down of overall growth would simultaneously reduce inflation. It would also reflect some recovery of the drastically reduced bargaining power of workers and primary producers. But there are other, more worrying tendencies in operation, that suggest that the current global inflationary process has other factors pushing it which will not be so easily controlled. In other words, the possibility of stagflation – of rising prices combined with output recession or stagnation – cannot be ruled out.

To understand this, it is necessary to examine the forces behind the prices rises for different commodities. In the case of food, there are more than just demand forces at work, although it is certainly true that rising incomes in Asia and other parts of the developing world have led to increased demand for food. Four major aspects affecting supply conditions have been crucial in changing global market conditions for food crops.

First, there is the impact of high oil prices, which affect agricultural costs directly because of the significance of energy as an input in the cultivation process itself (through fertiliser and irrigation costs) as well as in transporting food. Across the world, governments have reduced protection and subsidies on agriculture, which means that high costs of energy directly translate into higher costs of cultivation, and therefore higher prices of output.

Second, there is the impact of both oil prices and government policies in the US, Europe, Brazil and elsewhere that have promoted bio-fuels as an alternative to petroleum. This has led to significant shifts in acreage as well as use of certain grains. For example, in 2006 the US diverted more than 20 per cent of its maize production to the production of ethanol; Brazil used half of its sugar cane production to make bio-fuel, and the European Union used the greater part of its vegetable oil production as well as imported vegetable oils, to make bio-fuel. This has naturally reduced the available land for producing food.

Third, the impact of policy neglect of agriculture over the past two decades is finally being felt. The prolonged agrarian crisis in many parts of the developing world; the shifts in acreage from food crops to cash crops relying on purchased inputs; the excessive use of ground water and inadequate attention to preserving or regenerating land and soil quality; the lack of attention to relevant agricultural research and extension; the over-use of chemical inputs that have long run implications for both safety and productivity; the ecological implications of both pollution and climate change, including desertification and loss of cultivable land: all these are issues that have been highlighted by analysts but largely ignored by policy makers in most countries. Reversing these processes is possible but will take time and substantial public investment, so until then global supply conditions will remain problematic.

Fourth, there is the impact of changes in market structure, which allow for greater international speculation in commodities. It is often assumed that rising food prices automatically benefit farmers, but this is far from the case, especially as the global food trade has become more concentrated and vertically integrated. A small number of agribusiness companies worldwide increasingly control all aspects of cultivation and distribution, from supplying inputs to farmers to buying crops and even in some cases to retail food distribution. This means that marketing margins are large and increasing, so that direct producers do not get the benefits of increases expect with a time lag and even then not to the full extent. This concentration also enables greater speculation in food, with more centralised storage.

As the global financial system remains fragile with the continuing implosion of the US housing finance market, investors are searching for other avenues of investment to make up their losses. Commodity speculation is increasingly emerging as an important area for such financial investment. (Incidentally, this is one reason why there is so much pressure from the finance lobby even in India to allow the commodities futures market to develop.) Such speculation by large banks and financial companies is in both agricultural and non-agricultural commodities, and explains at least partly why the very recent period has seen such sharp hikes in price.

Commodity speculation has also affected the minerals and metals sector. For these commodities, it is evident that recent price increases have been largely the result of increased demand, especially from China and other rapidly growing developing countries, but also from the US and European Union. A positive fallout of the recent growth in demand and diversification of sources of demand is that it has allowed primary metals producing countries, especially in Africa, to benefit from competition to extract better prices and conditions for their mined products. But there is also the unfortunate reality that higher mineral prices have rarely if ever translated into better incomes and living conditions of the local people, even if they may benefit the aggregate economy of the country concerned.

At any rate, metal prices are high and likely to remain high because of the growing imbalance between world supply and demand. A reduction in global output growth rates would definitely have some dampening effect on prices from their current highs, but the basic imbalance is likely to continue for some time. This is also because there has been a neglect of investment in this sector as well, so that building up new capacity will take time given the long gestation period involved in investments for metal production.

So the medium term outlook for global commodity prices, while uncertain, is that they are likely to remain high even if the world economy slows down in terms of output growth. What does this mean for India? Until the 1990s, both producers and consumers in India were relatively sheltered from the impact of such global tendencies because of a complex system of trade restrictions, public procurement and distribution and policy emphasis on at least food self-sufficiency.

The liberalising policies that began in the early 1990s have rendered all of that history, since one explicit aim of the reform strategy was to bring Indian prices closer in line to world prices. As a result, especially with respect to food, both producers (that is cultivators) and consumers are now more or less directly affected by global trends. The increases in price have not been as sharp for some commodities, but they have nonetheless been significant, and in a country with a dominantly poor population whose incomes are not indexed to inflation, they are already unacceptably large. Yet Indian farmers have not seen the full benefit of these price hikes.

Thus, while world wheat prices (in rupee terms) increased by 92 per cent in the year to February 2008, Indian prices have increased by 33 per cent. Similarly, global soya bean prices increased by 65 per cent over the same period, while Indian prices went up by 34 per cent. Our wheat and soya bean prices are still below world prices so that further integration will only cause further increases in domestic price. Indian rice prices have gone up less than world prices only because exports have been prohibited.

The government’s response to the domestic price rise, which is already creating panic in official corridors in an election year, has been to reduce or eliminate import duties on several food items such as edible oils, so as to allow imports to bring the price down. But that is a short-sighted and probably ineffective strategy. It provides direct competition to Indian farmers producing oilseeds, even as they suffer rapidly rising costs. It sends confused signals not only to farmers for the next sowing season, but also to consumers, and leaves the field open for domestic speculators as well because the imports are not under public supervision but left to private traders.

Most of all, given the tendency of international commodity prices noted here, it will not solve the basic problem of rising inflation in such commodities. Instead, it will make the Indian economy even more prone to the volatility and inflationary pressure of world markets.

Therefore, the Indian economy cannot hope to remain insulated from these global trends without much more proactive policies that rely substantially on government intervention in several areas. In the case of food, this essentially requires a more determined effort to increase the viability of food cultivation, to improve the productivity of agriculture through public measures, and to expand and strengthen the public system of procurement and distribution. For other commodities too, it is now evident that a lassez faire system is simply not good enough, and public intervention and regulation of markets is essential.