Guess What’s Coming to Dinner? Inflation!

Summary:

• Sharp increases in grains prices this year may have an unexpectedly broad impact on inflation generally
• Energy price declines appear to be over and base effects turn positive in 2021
• Breakevens are at levels consistent with pre-Covid levels, when food prices were far lower and energy prices in a declining trend

Market Impact

• Breakevens present asymmetric upside given these developments, offering an attractive risk/reward

Prices of the three major grains – soyabeans, wheat and corn – have risen strongly this year (Chart 1). There are several factors involved, but highly unusual global weather patterns are not among them. Rather, there have been some production, transport and processing bottlenecks related to the lockdowns, as well as idiosyncratic factors.

While grains prices naturally spike on occasion due to the vagaries of weather across the major growing regions, it is rare for all three to rise by double-digits simultaneously. Yet this is precisely what has happened in recent months. Wheat and corn prices are up some 12% y/y, and soyabeans are up over 30%, the largest such rise since 2016. Grains are a major source of nutrition (and soyabeans of protein too) for much of the world. As such, if this rise is sustained for a full season or more, it will likely place upward pressure on food prices generally.

Food prices deserve special consideration for their potential impact on the overall level of price inflation. While food represents only a small part of the developed world’s respective official inflation baskets, it takes a large share of those in the developing world, where much of the world’s manufacturing infrastructure and workers are now located. Should food prices rise enough, and for a sustained period, those workers are going to demand higher wages. In turn, higher manufacturing costs are going to be at least partially pushed through to increased prices for exports to the developed world.

Placed alongside the recent recovery in energy prices, this could be a recipe for sharply higher inflation in 2021. The base effect of the lockdown plunge in energy prices will roll off early next year, and oil prices are already more than 30% off their lockdown lows.

It is debatable to what extent a combined food and energy shock, including the possible pressure on developing world manufacturing export prices, would have on core rates of inflation and central bank policy. However, breakevens would almost certainly have to take notice. As it stands now, US breakevens are close to their levels from early this year, before the Covid scare and associated lockdowns arrived on the scene (Chart 2). That seems increasingly inconsistent with recent food and energy price developments.

Were food and energy price effects to drive headline inflation sharply higher in 2021, central banks would most probably dismiss these effects as temporary and, perhaps, even welcome them. Such rhetoric, however, could encourage speculators to become more aggressive in playing for even higher breakevens than implied by food and energy price developments alone.

In any case, from the current starting point, the outlook for breakevens appears asymmetric to the upside and so an attractive risk/reward proposition.