Guest Editorial
The implications of ‘agflation’

by Marc A.H. Beck

Marc A.H. Beck is senior vice president of marketing for the U.S. Dairy Export Council. He contributes this column exclusively for Cheese Market News®.

Record-high prices for agricultural commodities have been a boon to dairy exporters this year, but the run-up will undoubtedly have repercussions on how we do business in the years ahead.

Global food marketers felt the first blow this year in the form of lower margins. Competitive pressures prevent companies from passing higher prices through right away, so in the short-term they absorb the higher cost at the expense of profits. In the United States, Dean, Kraft, Hershey’s and Starbucks recently posted earnings warnings due to costlier dairy inputs. Overseas, Nestlé and Cadbury Schweppes just did so as well.

Before long, though, food companies have to raise retail and menu prices. This month, major Taiwanese dairy suppliers moved prices up 10-15 percent and Vietnamese infant formula manufacturers hiked prices 5-10 percent (for some, it marked the third increase this year). Leading co-ops in India lifted milk prices about 5 percent. On Sept. 1, Morinaga Milk Industry in Japan will raise cheese prices nearly 10 percent, the company’s first price increase in a decade. In China, the nation’s major milk suppliers jointly agreed to cancel sales promotions to cut costs and thereby forestall further price hikes.

Similar stories have come out of Mexico, Indonesia, Malaysia, the Philippines, Pakistan, Russia and others.

And foodservice operators are under the same pressure.

“With so many commodities at or near (their) 10-year high, chances are consumers will have to get used to higher prices,” said David Brandon, CEO of Domino’s Pizza, during a recent earnings conference call.

This month, more than 20 Chinese fast food chains raised prices to offset rising input costs. In fact, food prices have risen so fast in China — up 7.6 percent from a year ago — that authorities have launched an investigation into possible collusion. Subjects of the inquiry include pork, beef, poultry, grain and vegetable oil. Any complicit deal “seriously disrupts normal price order and influences social stability,” the government’s National Development and Reform Commission says.

And yet higher overall prices may be here to stay — with profound implications. It’s a phenomenon some economists have dubbed “agflation.”

Last month, Peter Brabeck, the chairman of Nestlé, predicted the emergence of an era of “significant and long-lasting” food inflation — in part due to interim factors like weather events, but also because of long-term, structural changes such as demand from China and India and the use of crops for biofuels.

Brabeck’s comments echo the conclusions of the latest “Agricultural Outlook” annual report from the Organisation for Economic Co-operation and Development (OECD).

“Structural changes such as increased feedstock demand for biofuel production, and the reduction in surpluses due to past policy reforms, may keep prices above historical equilibrium levels during the next 10 years,” the outlook report says.

• Food vs. fuel

“Biofuels have tied oil and food prices together in ways that could profoundly upset the relationships between food producers, consumers, and nations in the years ahead, with potentially devastating implications for both global poverty and food security,” write C. Ford Runge and Benjamin Senauer in the May/June 2007 issue of Foreign Affairs.

“Biofuels may have even more devastating effects in the rest of the world,” the Foreign Affairs article continues. “Studies by economists at the World Bank and elsewhere suggest that caloric consumption among the world’s poor declines by about half of one percent whenever the average prices of all major food staples increase by one percent. When one staple becomes more expensive, people try to replace it with a cheaper one, but if the prices of nearly all staples go up, they are left with no alternative. All other things being equal … the number of food-insecure people in the world would rise by over 16 million for every percentage increase in the real prices of staple foods.”

In other words, in developing countries, where the poor spend a relatively high percentage of their income on food, the effect of high dairy prices on consumption could be magnified by high food prices.

The impact could be dramatic. Research from the Food and Agricultural Policy Research Institute (FAPRI) shows the price elasticity of demand for nonfat dry milk (NDM) in selected developing countries is -0.32. That means if NDM prices were to double, as they have in the spot market this year, demand would decline by 32 percent.

In addition, when the prices of all food staples increase, it has the same effect as reducing income because consumers have to spend more money to get the same amount of food. The income elasticity for NDM for the same selected countries was 0.52. That means if the percentage of income spent on food increased from, say, 25 percent to 45 percent, it would reduce demand for NDM by more than 10 percent.

Besides the likelihood of reduced sales, agflation has other potential implications. For example, a higher price-plateau would push policy reform further away from price support, says OECD. “This would reduce the need for border protection and would provide flexibility for tariff reduction,” the group says.

Inflation also accelerates the push for local production, rather than a reliance on imports. Throughout the dairy-deficit countries in Asia, for instance, high prices for imported dairy commodities have prompted calls for government incentives for domestic dairy development. But in the meantime, in those countries with long-standing dairy deficiencies that drive a reliance on imports, higher global prices can sometimes lead governments to lower their import tariffs, such as recently done in Egypt and Vietnam.

From a wider public policy perspective, inflation also typically leads to higher interest rates. This is already an issue in such disparate economies as New Zealand and Mexico. Higher interest rates could put additional pressure on consumers in developed countries, and stall investment from food processors.

Most consumers around the world have enjoyed relatively low food inflation for the last decade (South America being the notable exception). However, as structural changes make basic commodities costlier, a return to the high food inflation of the 1970s is poised to return, with a raft of new dynamics to consider.

CMN

The views expressed by CMN’s guest columnists are their own opinions and do not necessarily reflect those of Cheese Market News®.