El Niño and food inflation

Over the past year, lower oil prices highlighted disinflation risks and helped bond market performance across Asia. Now, however, investors are turning their attention to the risk of a rebound in food prices due to El Niño, a meteorological condition caused by oscillations in ocean surface temperatures.

During its previous bouts, in 2008 and 2011, El Niño exacerbated the inflationary pressure in Asia and prompted policy responses. A rebound in the headline consumer price index (CPI) now risks limiting policy options for central banks— particularly those that have inflation targets—at a time when the downside risk to growth is intensifying, as evidenced by the weaker manufacturing activity indicators in recent months.

An uptick in the El Niño/Southern Oscillation (ENSO) index in May this year drew the market’s attention to the risk of the El Niño effect, as the phenomenon is often associated with warmer and drier weather that could disrupt food supply.

However, a closer look at the ENSO index and food inflation in past cycles suggests that not all episodes of El Niño—or, elevated readings in the ENSO index—have resulted in food inflation, 1998–1999 being a prime example (Display 1).

Moreover, the El Niño effect must continue for some time before it results in food inflation. As of now, we have just two consecutive months of an uptick in the ENSO index for the Asia-Pacific region, and it’s also still one level below the highest reading. In our view, it’s still too early to conclude that El Niño and food inflation are returning.

Investors should also be aware that there is no direct relationship between the level of the ENSO index and the severity of food inflation. In some of the past episodes of El Niño, such as those in 2008 and 2010–2011, food inflation was significant and became a dominant driver of CPI inflation. But there are also cases in which food inflation stayed benign even during a significant El Niño. In addition, food prices respond to an ENSO index spike with some time lag, which means that even if El Niño were to disrupt food supply, it might only start to affect the CPI six to 12 months down the road.

Game changer?

In the absence of a broad-based commodity price inflation due to a lackluster global demand outlook, a rebound in food prices alone is unlikely to change the overall inflation picture of the region. In the past two episodes of El Niño and significant food inflation, the food component accounted for just 1.5–1.6 percentage points of Asia’s CPI inflation (Display 2).

This experience can help us evaluate the potential impact on the overall inflation picture. Regional inflation is now at cyclical lows, and there may not be much passthrough from El Niño, given the unimpressive growth rates. Even if there was a food inflation comparable to 2008 or 2010–2011, that should only bring the regional CPI back toward its long-term average of around 3%–4%. That is fairly benign, and swings in food prices per se typically do not have big monetary policy implications.

Better inventory levels on net basis

Looking at the supply/demand dynamics, there are also other factors that could mitigate the severity of any El Niño–driven inflation in the coming months. The current inventory levels for wheat and rice are similar to those in 2010–2011 and better than those in 2007–2008 (Display 3).

Wheat has a relatively small weight in the CPI basket across the region anyway because it’s not a staple in most Asian diets. And as for rice, the region has been largely self-sufficient, even during the previous droughts. Meanwhile, Asia is a net importer of coarse grains, mainly used for animal feeds. Global price fluctuations in coarse grains may have a more direct impact on domestic costs. In fact, during the previous two episodes of food inflation, surging meat prices were a key driver of the consumer price inflation. But the inventory of coarse grains is now at a much more comfortable level than before, offering some buffer against a global price rebound. Thus, in terms of the stockpile, the region is better positioned than before to withstand any El Niño effect.

Limited secondary effect

Lastly, the secondary effect on broader prices should also be a smaller concern than in the previous El Niño periods. Back in 2008 and 2011, the Asian economy was growing beyond its potential growth level, as estimated by the output gap using the Hodrick-Prescott (HP) filter. Core inflation had already been rising when food prices surged. By comparison, there is growing evidence of a greater economic slowdown across the region since the second quarter this year. Exports have been deteriorating, while lackluster domestic demand has kept the core CPI inflation benign. In such an environment, the secondary effect should not be a major concern (Display 4). While monetary tightening by Asian central banks in response to rising inflation in the previous cycles was justified from an economic fundamental perspective, a potential food inflation in the near future driven by external factors should not by itself result in policy responses. All in all, even though the risk of El Niño has increased, it is still too early to judge whether it will persist. There’s even more question about whether the effect would induce a food price inflation and whether that would affect broader consumer price inflation. So, for policymakers and bond investors, the downside risks to growth and other external uncertainties continue to be greater concerns, at least for now.

By Vincent Tsui, Economist, Global Economic Research and Anthony Chan, Asian Sovereign Strategist,Global Economic Research, AB

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