“Why falling food prices mean the US Fed won’t probably raise rates (yet)?”: analysing the pros and cons

In anticipation of this coming week’s US Fed meeting to decide on short-term interest rates, some analysts have been discussing an interesting link between food prices and the US Fed rates. Whether their forecast turns out to be true or not, the logic and analysis are very insightful. Here is how it goes…

As the latest figures from the UN Food and Agriculture Organisation indicate, with a 5.2% drop, global food prices have fallen at a fast rate in the past seven years.

Pressures on prices are coming from all fronts:

  • From the Chinese front because demand is slowing as a direct consequence of the weaker economy, and therefore lower imports, which is likely to weigh on corn, barley and sorghum prices.
  • From the Russian front because of the embargo on Western products.
  • And ironically because of the excellent crops in Australia, Europe, Russia and Ukraine. A bizarre case of what is supposed to be a good thing, turning into a not so good consequence…

So what’s the link with the US Fed?

This steep drop in agricultural prices, which fuels the growing deflationary pressures sweeping through the global economy, will be a major cause of concern for US Federal Reserve officials as they debate whether to raise short-term interest rates at a crucial Federal Open Market Committee (FOMC) meeting this coming week.

The meeting will be a key test of whether US central bank boss Janet Yellen – who has consistently told investors to prepare themselves for a US rate hike this year – is able to forge a consensus among the top policy-makers, despite their widely divergent views.

One group of US central bank officials believe that the strong improvement in the US jobs market means that the Fed raise its benchmark short-term interest rate – which it has kept close to zero since December 2008.

This hawkish camp believes that the drop in the US unemployment rate, which fell to 5.1% in August from 5.3% in July, plus the surge in job openings in July point to a growing demand for workers, which is likely to push wage rates higher, which will ultimately translate into higher US prices.

They’re also concerned that the US central bank runs the risk for fueling asset price bubbles if it keeps interest rates close to zero for too long. As a recent NYTimes Op-Ed put it:

<< The financial markets and the Federal Reserve Board have been playing out a tragicomedy in three acts. Here’s how it works:

Act I: Initially, a flurry of news stories appear about how, a few months hence, the Fed intends to raise short-term interest rates for the first time in years.

Act II: Second, the predictable market swoon, as Wall Street traders ponder the fact that the morphine drip of free money that they have been enjoying since the aftermath of the 2008 financial crisis might be pulled out of their arms.

Act III: Finally, the Fed backs away from its much overdue policy change, causing traders to rejoice and the artificially stimulated bull market in both stocks and bonds to continue. The curtain comes down, and the audience roars its approval. >>

Then on the contrary, other Fed officials believe that the combination of a strong US dollar, falling commodity prices and the threat of a vicious slowdown in China and the emerging markets mean that the safest course of action is to keep US interest rates steady.

To support their argument, they will point not only to the sharp drop in agricultural and other commodity prices, but also to the slide in US import prices.

The trouble is deflation

These deflationary pressures are making it increasingly difficult for the US central bank to believe it is on track to reach its target of a 2% inflation rate. i.e. it will be below 2%, and if it is the case, higher rates would not help…

According to a report released this week gives details on the mechanics of this low inflation: the price of US imports dropped 1.8% in August from the previous month, leaving them 11.4% below their level a year ago – the largest annual decline since 2009.

Although the fall largely reflected the plunge in crude oil prices, there were declines in other sectors. For instance, prices for consumer goods (excluding automobiles) fell by 1.2%, a bigger drop than that recorded during the financial crisis.

It will probably take some time for retailers to pass on these lower import prices to US consumers, but they will eventually be reflected in lower US inflation.

What’s more, the downward pressure on import prices combined with the chill winds of China’s slowdown spread through the emerging world, stifling demand and exacerbating the over-supply problems.

These deflationary pressures are intensified by the rising US dollar – which has climbed almost 20% since the middle of last year. Again the effect of the rise in the US dollar, the strongest since the late 1990s, has not yet been fully reflected in lower US consumer prices.

With these growing deflationary forces making the Fed’s target of 2% inflation looking increasingly elusive, it would be a brave move by Yellen to push ahead with an interest rate rise.

Given that the US central bank will once again be forced to downgrade its inflation projections, Yellen will be deeply worried that even a small rate hike will boost deflation, and result in even lower US consumer prices.

Xavier – 14 September 2015 – Sydney


FURTHER INSIGHTS:

1 > On the contrary, other observers believe that the US Fed is ripe for a rise:

For instance, Westpac’s Chief Economist Bill Evans says he has been forecasting that the Fed would start raising rates in September 2015 for around two years.

His thesis in a nutshell – exposed in businessspectator.com.au :

It has been a long wait and despite market pricing only giving a 30% probability to the hike occurring, he is sticking with the view. Markets are more confident that the Fed will wait until December on the basis that the Fed surprised by delaying the decision to reduce Quantitative Easing to December when the scene was set for September.

Bill Evans thinks Fed authorities might see that decision as, in hindsight, adding unnecessary uncertainty to the market and forcing a major policy change into a time of limited market liquidity.

The US labour market and inflation, rather than global demand or equity market volatility, will be the key drivers of the Fed’s decision.

The chair of the Fed, Janet Yellen, is a renowned labour economist. She has spoken regularly on the various measures (other than just the unemployment rate) of the state of the labour market, including job openings; labour turnover; confidence around job prospects; and the proportion of unemployment represented by the long-term unemployed.

The US unemployment rate has now fallen to 5.1% from 5.3% in July (and down from the 10 per cent it reached in the aftermath of the global financial crisis). This is a level generally associated with full employment. Also, this week’s data on job openings (jobs available but not filled) jumped by 8% in July to be up 22% over the year.

This points to significant healing in the US labour market. Even if some economists might point to some slack, possibly because of (lagging) soft wages growth, there cannot be a case to support zero interest rates from the perspective of the labour market.

The other variable on the Fed’s ‘check list’ is inflation. Annual growth in the Fed’s preferred inflation measure, core PCE, is 1.2%, well below the target level of 2%.

But for Bill Evans, the Fed only needs to be confident that core PCE inflation is moving towards the 2% target as it accepts that it should not be waiting to begin the tightening process until the target is reached. In that regard, it was interesting that vice-chairman Stanley Fischer chose the topic of inflation when he spoke to the important Conference of Central Bankers at Jackson Hole late last month. For him:

  • “there is good reason to believe that inflation will move higher as the forces holding inflation down – oil prices and import prices, particularly – dissipate further.” In other words, Fischer believes falling prices was largely the result of the crash in energy prices, which he considers to be a ‘one-off event’. (That’s an important debate: will oil go as low as $30 as you would expect if the embargo on Iran stops and more supply comes to the global market? Or will it bounce back?)

  • Another large effect comes from changes in the exchange value of the dollar, and the rise in the dollar over the past year is an important reason inflation has remained low. A higher value of the dollar means lower import prices. To give an idea of the magnitude of the effect, Fed research has calculated that the impact of a 10% in the US dollar was to reduce inflation by 0.5% after around one year. Fisher noted that the US dollar had appreciated by 17% over the last year, implying that it eventually has to stabilise, which would in turn eventually see inflation move back by around 0.8%.

If you believe such a scenario, inflation will move back to 2% once the USD stabilised. That analysis indicated that the Fed’s models are providing comfort that US inflation will move back towards 2% over the course of the next six months or so.

A “so what?” is that given that Interest Rate Markets are largely in denial about a Fed move, Evans expect some volatility around the short-end of the yield curve. Markets are currently only pricing a Federal Funds rate of 0.75% by end-2016. If there were a move next week, then that pricing would imply only one more hike plus a 50% chance of a second hike by end-2016. Markets would need to totally re-assess such a complacent approach (which still believes in cheap money – the aforementioned ‘morphine drip of free money’) if the FED does move.

On the other hand, history shows that Equity Markets generally responded positively as the rising Federal Funds rate coincided with an improving economy and increased prospects for earnings (as they did in 1994, 1999 and 2004). So the ‘fear factor’ effect for US equities might already be behind us as equity markets have already reacted to the realistic prospect of a Fed move.

2 > The social ripple effect of those falling food prices on European farmers (as if Europe  didn’t have enough problems already):

– UK farmers forced to borrow money: continuing collapsing food prices are bad news for British farmers, who are already struggling with a supermarket price war and changes to subsidy payments that could see many forced to increase their levels of borrowing this winter. Lloyds Banking Group has already set up a £500m emergency fund to help struggling British farmers facing late subsidy payments under the new Common Agriculture Policy.

– The European Union was forced to dole out €500m (£363m) in emergency funding for hard-pressed farmers across the continent who face being wiped out by a collapse in the price of dairy produce and meat.

– In Paris, hundreds of French farmers and more than 1,300 tractors have converged to the city centre in the latest protest against their collapsing incomes. The protesters want to put maximum possible pressure on Francois Hollande’s government, which has already given way once, just six weeks ago, with a package of debt relief worth €600m (US$674m). But the farmers say that they need much more, arguing that French agriculture is on the verge of collapse.

The French government has estimated that around 10% of farms in the country with a combined debt of €1bn now face bankruptcy in 2015: that is approximately 22,000 sites…

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