Commodity Prices and Global Inflation
First Deputy Managing Director, International Monetary Fund
At the Council on Foreign Relations
New York City, May 8, 2008
A broad consensus has emerged in recent weeks regarding key aspects of the global economic outlook. In particular, it is widely agreed that global growth is slowing, reflecting asset price declines (especially in the US housing market and in global equity markets), the associated financial market turmoil, plus rising energy and commodity prices.
The effects of the slowdown are being felt most keenly in the United States, but growth in all regions of the world is slowing. According to the IMF's latest World Economic Outlook, global output growth will slow by a full percentage point in 2008—to about 3¾ percent—and remain at that pace in 2009.
Despite the broad consensus about slowing growth, there is significant uncertainty regarding inflation. In the past, weakening global growth typically has been associated with receding inflation pressures. However, this has not been the case over the past year. Rather, headline inflation is accelerating. According to the IMF's International Financial Statistics, global consumer price inflation is now running at an annual pace of nearly 5½ percent, compared with less than 4 percent in recent years.
This acceleration in headline inflation in large part reflects the impact of higher energy and commodity prices. Nonetheless, this inflation speed-up must be taken seriously, as it creates potentially significant challenges to economic stability that could undermine prospects for restoring the combination of solid growth and low inflation that prevailed earlier in this decade.
To put the issue starkly, inflation risks have reemerged as a global challenge following a long absence. Rising energy and commodity prices are central to these new concerns.
I will focus my remarks today on three questions posed by these developments. First, does the increase in energy and commodity prices represent a durable relative price shift, reflecting long-lasting global demand and supply trends?
If this is the case, we will just have to get used to paying relatively higher prices for these items. However, unless prices just keep on rising more rapidly than other items, the relative shift will be finite—that is, it will represent a temporary boost to the general price level—rather than a source of permanently higher inflation. Policymakers' task would be to accommodate such relative changes appropriately, minimizing the resulting overall economic and financial disruption by preventing any deterioration in long-term inflation expectations. This appears to be a reasonable characterization of the current circumstances.
Second, have existing policies created at least some of the current price pressures? In particular, policies may be causing market distortions that explain both some of the relative price shifts and the resulting inflation pressures. Moreover, the potential for increased supply of those goods whose prices have been rising fastest may require policy support. In this case, specific policies are available that would tend to ameliorate the recent price shifts. Such a conclusion also appears to be justified at present.
Third, is it possible that the rise in headline inflation is boosting inflation expectations and/or reflects an incipient overheating of the global economy? In other words, is it possible that the current period bears similarities to the early 1970s, when rising energy and commodity prices ushered in a period of rising inflation expectations and sustained inflation pressures?
In this case, however, my Fund colleagues and I are optimistic that this conclusion is not justified, at least not at this time. Nonetheless, a more pessimistic conclusion cannot be discarded out of hand.
Thus, central bankers and fiscal policy authorities need to pay close attention to potential inflation risks. Specifically, signs of more general inflation pressures would justify a decisive policy response, lest the impressive gains in global stability attained in recent years be sacrificed.
The goal of the IMF and its member countries is to return the global economy to a path of strong and stable growth, accompanied by low and stable inflation. The principal conclusion that I would like to emphasize today is that achieving this goal in the current circumstances will require a coherent set of policy responses across a broad front. These will include structural measures designed to improve market efficiency, as well as possible monetary and fiscal policy adjustments. The stakes are high and the responsibilities in this effort inevitably will have to be shared globally.
Factors behind recent commodity price developments and global inflation
Why, at a time when the global economy is slowing and the largest economy is on the brink of recession, are energy and commodity prices still so high, and in some cases, still rising? Fundamentals—including shifts in demand and supply over the past several years—provide much of the explanation.
Demand for energy and commodities has remained robust reflecting especially the strong growth in emerging and developing economies, led by China and India. These economies' growth is more energy- and commodity-intensive than that of more developed economies.
In fact, emerging and developing economies as a group have accounted for about 95 percent of the growth in demand for oil since 2003. The prospect of a continued relatively strong expansion in these economies suggests that demand growth for energy and commodities will remain solid, even as global growth is slowing.
At the same time, the supply response to rising prices has been disappointing:
• For oil, supply projections have routinely been revised downward in recent years, particularly for non-OPEC oil producers. Costs associated with investment in new capacity have increased significantly—market estimates suggest that average field exploration and development costs have doubled, from $5 a barrel in 2000 to $10 a barrel in 2007. As spare capacity and inventories have dwindled, the oil market has become highly sensitive to news of supply disruptions and geopolitical events. This has pushed oil prices to all-time highs in real terms, surpassing their previous 1979 peak by some 16 percent.
• In the case of food, supply constraints are also relevant. Agricultural production costs—and associated transport costs—are responding to rising oil prices. Temporary factors, such as droughts and bad harvests in some regions, have also played a role. That said, by historical standards, real food prices are still well below previous peaks.
• With only temporary relief likely, we expect that agricultural prices will remain high for the foreseeable future, as supply responses may require both new investment and policy reforms. These inevitably will take time. Hopefully, the inflationary impulse from higher food prices will wane, even if prices do not retreat significantly. However, this also indicates that the humanitarian challenges of higher food prices will not disappear any time soon.
• Prices of base metals—which tend to be the most sensitive to business cycle fluctuations among commodity prices—peaked in May 2007 and fell by 20 percent in the second half of 2007 on slowing global manufacturing activity and a recovery in inventories from very low levels. However, prices have recovered most of these losses this year because of supply concerns and, to a lesser extent, the weakening of the US dollar.In sum, the factors underlying the relative price shifts for energy and commodities appear to be fundamental in nature. This means that much, if not most, of the recent price increases are likely to prove durable if the IMF global growth forecast is reasonably accurate. But they do not inevitably lead to sustained faster inflation.
Turning to my second question, economic policies have also contributed to, and in some cases exacerbated, demand-supply imbalances.
• On the demand side, many emerging and developing countries have adopted policies that hinder the full pass-through of international prices to domestic consumers by subsidizing or capping fuel prices. Recent IMF research suggests that, of a sample of 43 emerging and developing economies, fewer than half allowed full pass-through of the increase in international prices in 2007 compared with three-quarters in 2006.
• In these circumstances, prices cannot play their natural role in moderating demand. Of course, policymakers naturally want to buffer consumers from brusque price shifts. In the absence of a systematic approach to price adjustments, however, it is politically tempting to create new and distorting subsidies that are destabilizing in the longer run.
• On the supply side, national policies that affect the domestic investment climate influence supply trends. For example, our research indicates that investment in new oil capacity is higher in countries with better investment climates and stronger corporate and sectoral governance.
• With respect to food, biofuels policies in some advanced economies are spilling over to the price of key food items, particularly corn and soybeans. IMF estimates suggest that increased demand for biofuels accounts for 70 percent of the increase in corn prices and 40 percent of the increase in soybean prices. At the same time, oil prices likely would have been higher in the absence of these biofuels, making overall judgments more complex. However, these subsidies do not promote economic efficiency as an offset to their inflationary impact.
• Policies in some emerging economies have also played a role in the run-up in food prices. Lack of investment and extensive government involvement in pricing, marketing, and distribution in some key crop-producing countries has limited the dynamism of food production. In any case, agricultural productivity is low in many emerging economies—in Asia for example, industrial productivity is about 3½ times higher than agricultural productivity, compared with 2½ times in Latin America and1½ times in non-Asian advanced economies. Without a doubt, there is scope for substantial improvement. However, such improvements will require time and concerted efforts.
• More recently, export restrictions—motivated by the desire to ensure that domestic populations have sufficient food—are having negative effects on countries that rely on food imports, including some of the very poorest countries with highly vulnerable populations.
• In the case of rice, where the export market is small and segmented, preliminary estimates suggest that export restrictions, and the resulting panic buying, explain about 50 percent of the recent increase in prices. Such restrictions are also reducing incentives to increase production in exporting countries.
Finally, in recent months, financial factors may have played an increasingly important role in the evolution of oil and other commodity prices:
• Preliminary evidence suggests that low interest rates have a statistically significant impact on commodity prices, above and beyond the typical effect of increased demand. Exchange rate shifts also appear to influence commodity prices. For example, IMF estimates suggest that if the US dollar had remained at its 2002 peak through end-2007, oil prices would have been $25 a barrel lower and non-fuel commodity prices 12 percent lower. At the same time, however, IMF analysis indicates that the dollar's adjustment since 2002 will have reduced the currency's earlier overvaluation, and should prove to be supportive to a reduction in global payments imbalances.
• The easing in US monetary policy also has tended to generate an easing in monetary conditions in countries with currencies closely linked to the dollar. In some economies in Asia and the Middle East, rising commodity prices have exacerbated general inflation pressures, while an easing of conditions has made monetary policy overly-accommodative.
Tackling the Problem—Policy Challenges
So how can these problems best be tackled? In the Fund's view, policies will need to adjust both to the reality of permanent relative price shifts and, in some cases, to a broader resurgence in overall inflation.Advanced, emerging and developing economies alike have a role to play in ensuring that policies do not hinder the restoration of demand-supply balances in commodities markets. Let me elaborate on our views regarding appropriate structural policies:
• First, given that some portion of the latest increases in oil prices appears to be durable, allowing a demand response to the reality of higher oil prices will be crucial. Indeed, the pass-through of changes in international oil prices to domestic prices would help promote an inevitable demand response to changing market conditions and encourage conservation. At the same time, well-targeted policy supports should be put in place to protect the most vulnerable groups.
• Second, policies are needed to foster investment in the oil sector and in energy resources more generally. These include efforts by oil producers—particularly those in emerging and developing countries—to ensure that investment regimes are stable and predictable, encourage greater cooperation and synergies between national and international oil companies through well-designed partnerships, and facilitate the establishment of an orderly, predictable, and transparent market through improved data dissemination on demand and supply conditions.
• Third, efforts to reduce the level of protectionism and subsidies aimed at stimulating biofuels production would remove distortions and allow for greater overall efficiency. In addition, policies to increase conservation and energy efficiency would help to moderate the growth in energy demand.
• Fourth, agricultural policies can be improved in many emerging and developing countries. Absent sufficient infrastructure to increase cultivation, boost productivity and to bring agricultural products to the market, the supply response in these countries may remain elusive. Thus, policies should aim to upgrade infrastructure, distribution, and storage systems, expand irrigation systems, and redirect subsidies toward high-yield products and key agricultural inputs such as fertilizer. At the same time, subsidized production in advanced countries should be phased out over time, rather than continue to undercut production incentives in developing and emerging economies.
Macroeconomic policies also will be critical.
• In United States, policy interest rates have been reduced significantly as the growth outlook has deteriorated. As US growth recovers, developments in inflation and inflation expectations will assume greater importance for policymakers. The 2008 fiscal stimulus should help provide some cushion for demand. However, any new fiscal measures could focus on stabilizing key sectors that are vital to limiting downside risks to growth, such as the housing sector and the financial system.
• In the euro area, the sharp rise in inflation and concerns about potential deterioration in inflation expectations are dampening consumer confidence and spending. The inflation outlook appropriately is central to the ECB's policy considerations. Policy prospects could shift, however, if inflation expectations remain well anchored and slowing growth reduces inflation pressures. For Japan, core inflation remains very low at 0.1 percent, and given the uncertainty concerning growth prospects, Bank of Japan policy is not expected to change soon.
• For emerging economies with currencies closely linked to the dollar that are facing overheating concerns, macroeconomic policies need to be tightened in response to generalized inflation pressures. In China, movement toward a more flexible exchange rate regime could provide greater scope for effective and stabilizing monetary policy action. Among Middle Eastern commodity exporters, fiscal spending should be aimed at alleviating supply bottlenecks—particularly related to infrastructure—that have contributed to inflation pressures.
Concluding remarksWith regard to the IMF, we are dedicated to helping our 185 member countries confront the current challenges. The Fund's mandate is to promote global financial and economic stability, as a basis for sustained global growth and prosperity. The scope of the recent run-up in energy and commodity prices underscores their macroeconomic significance, putting the inflation risks posed by rising energy and commodity prices squarely within the Fund's mandate.
The global scope of these developments also underscores that a successful response will have to be globally consistent and coherent.Of course, the challenges created by these price rises extend beyond the Fund's mandate. Indeed, the UN Secretary General has convened a Task Force on Food Prices—comprising the Fund, the World Bank, the WTO, and other UN agencies —help to coordinate the international community's response. Within this broader context and in line with our mandate, the Fund is focusing on several specific areas, including:
• The provision of financial assistance and policy advice to countries that are negatively affected by the latest international price developments; in particular, we currently are in active discussion with 10-15 low-income member countries regarding possible balance of payments financing.
• Economic research aimed at a better understanding of the causes of the recent energy and food price increases, the effect of financial fundamentals on prices of oil and other key commodities, and the impact of fuel and food prices on overall inflation and on the macroeconomic outlook more generally.
• Development of risk management and mitigation tools and strategies that could be used by our members.The current challenges to global prosperity and progress are potentially serious, and contain many novel elements. However, they can and will be surmounted successfully, so long as the responses are appropriate, coherent and consistent in a global context. That is a key underlying reality of our global economy.