We were wondering how long the Goldman economic koolaid team would continue living in a pretend "priced to perfection" reality. The answer is just 2 under months. After ignoring the topic of surging food prices, head economist Andrew Tilton finally decides to discuss the issue (following 5 countries with violent riots demanding to learn much more about the issue). Not surprisingly the conclusion is one that will not make any dent on the firm's Goldilocks outlook for a QE-inspired, pretend economy. While Tilton attempts to preserve some credibility by noting that yes, it could get very bad, his conclusion is one of keeping to the party line, i.e., that everything will be ok and that much time has to pass before things get bad, even if they were to get bac. To wit: "the recent surge in food commodity prices poses upside risk to both our core and headline CPI forecasts, particularly the latter. The rise in food costs should push up headline CPI inflation by roughly ½ point even without meaningful pass-through effects into the core index, reducing household real income growth accordingly. While clearly undesirable from the standpoint of households, these results suggests that as long as commodity prices stabilize relatively soon, the burst of food inflation would not have a major impact on the broader economic outlook." And what happens if commodity prices do not stabilize "relatively soon", which they won't as long as Ben Bernanke continues to step in for the increasingly sparser foreign Treasury purchasing interest (also known as the Frost-Sack Top Secret "Dow 36,000 Project").
Full Andrew Tilton note:
Prices for food commodities have surged in recent months, with our Goldman Sachs Commodity Agriculture & Livestock index up 60% since its recent trough in mid-June 2010.
Higher food costs have yet to reach the retail level. Our analysis suggests an average lag of seven months from commodity price changes to retail food price changes. Typically, retail food prices move about one-tenth as much as commodity prices. Of course, there is significant variation in both the time lag and the degree of pass-through in individual episodes.
If commodity prices held steady at current levels, we would expect to see consumer food inflation accelerate from roughly 1% over the past year to about 5% in mid-2011, contributing about ½ point to the headline Consumer Price Index. Pass-through into core could also be a few tenths of a percentage point, although there is considerable variation around this outcome. These results suggest that the burst of food inflation seen thus far poses modest upside risk to our current inflation forecasts, but not a major threat to the broader economic outlook.
Prices for food commodities have surged in recent months. Cash prices of grains such as corn and wheat have nearly doubled over the past half-year. Our Goldman Sachs Agriculture & Livestock index, a component of the overall GS Commodity Index, is up 60% since its recent trough in mid-June 2010.
Despite the sharp increases in farm prices, higher food costs have yet to reach the retail level. The food component of the Consumer Price Index is up just 0.8% since mid-2010 and 1.5% year-over-year. Commodity prices and consumer prices for food diverge for two main reasons:
1. Other costs dilute the effects of raw commodity price changes. Commodity food costs are only a small portion of the final consumer prices of food. Even raw vegetables at the grocery store incorporate some labor and transportation costs associated with getting the product from the farm to the store shelf. Much of the food that consumers purchase has been processed considerably and packaged, adding further layers of cost. And the food CPI includes food served at restaurants, which incorporates further costs of service. All of these other costs generally move much less than commodity food prices, diluting the effect at the consumer level. As a rough rule of thumb, we find retail food prices move a bit less than one-tenth as much as our GSCI Agriculture & Livestock index.
2. Time lags from farm to store. It takes time for commodity price changes to be reflected at each stage of the food production chain. On average, we find the highest correlation between commodity and retail food price changes at a seven-month lag.
Illustrative Food Price Pass-Through and Lag Times
To estimate the likely impact of the sharp rise in food commodity prices on the Consumer Price Index, we constructed a model linking the food CPI to 1) the GSCI Ag/Livestock index and lags, 2) lagged core CPI inflation (as a proxy for the underlying inflation trend), and 3) capacity pressures, specifically the capacity utilization rate in the food manufacturing sector and the unemployment rate. Using quarterly data from 1985 through 2010, the model suggests that if food commodity prices stayed at current levels, the 60% increase in food commodity prices to date would push food CPI inflation to around 5% (annualized) in Q2 and Q3 2011. On a year-over-year basis, the food CPI would probably peak in the 4%-4½% range.
What does this mean for the more commonly followed headline and core CPI measures? The total effect on the CPI includes both direct and indirect effects. Food has a relative importance weight of 13.7% in the overall CPI, so the sort of acceleration we envision would make a direct contribution of approximately ½ percentage point to headline CPI inflation in mid-to-late 2011.
Food inflation also could have indirect effects on the CPI by pushing up prices of specific items within the core index. This could occur because companies in other sectors provide food to their employees or to customers as part of their business, and are able to pass the incremental food input cost on in their final prices. Or it could conceivably occur if higher food price inflation nudged up inflation expectations, which then affected wages and/or prices more broadly. In any event, we do find some evidence that food prices push up core inflation slightly (specifically, core goods and some core services, but not rents). Food price inflation in the CPI along the lines of the scenario above might push up core inflation a few tenths of a percentage point over the subsequent year; though as with pass-through from commodity to CPI food inflation, results can vary significantly from one episode to the next.
In summary, the recent surge in food commodity prices poses upside risk to both our core and headline CPI forecasts, particularly the latter. The rise in food costs should push up headline CPI inflation by roughly ½ point even without meaningful pass-through effects into the core index, reducing household real income growth accordingly. While clearly undesirable from the standpoint of households, these results suggests that as long as commodity prices stabilize relatively soon, the burst of food inflation would not have a major impact on the broader economic outlook.