News about rising international food and oil prices are often treated as good omen for the region’s corresponding exporters. However, this is only a partial and benign take on the issue. First of all, there are the domestic inflationary shocks posed by those price hikes. Secondly, the net impact of higher food and oil prices varies substantially from positive to negative among countries in the region, with likely redistributive effects against the poor derived from higher food prices. Thirdly, such an environment constitutes a slippery slope on which policy pitfalls often become harder to avoid.
1. Rising Inflation
Chart 1 below exhibits how inflation has trended upwards in all countries included in the sample, a feature shared throughout the region. Food prices have been the major factor underlying the increase of headline inflation, while fuel prices have not entirely reflected international oil prices, as a result of detachment policies that we approached here last June 10. Exhibit 4 shows that the average evolution of fuel prices has not accompanied recent oil price spikes.
Chart 1: Inflation in Latin America
CPI core ex-food and fuel indexes have also drifted upwards, revealing a propagation of primary shocks. Indeed, market expectations regarding inflation have been moving upwards, as revealed by the latest information collected by the Inter-American Development Bank – IADB (see REVELA). This is another signal that current inflation trends may be reflecting a process going much beyond basic adjustment of relative prices. Second-order effects are starting to show their ugly face.
The rise in oil and food prices can be explained by global imbalances of demand and supply, but from the individual perspectives of the economies in the region, those price hikes represent external shocks. These shocks have been partially mitigated by local currency appreciation in most cases and one has also to take into account domestic fiscal and monetary policies in order to understand the increases of inflation rates. After all, the propagation effects of primary shocks depend on the actual local environment in terms of domestic absorption vis-à-vis production capacity. Nonetheless, the current context poses some special challenges for the current fine-tuning of macroeconomic policies in the region:
(a) Given the fact that food and energy comprise a higher share of CPIs than in the average of the global economy, non-food-and-energy items would have to undergo a deep downward strain if they were to compensate food and energy and keep price indexes stable.
(b) Given the state of low real interest rates in developed economies, tightening monetary policy in most cases of the region tends to lead to a real exchange rate appreciation in addition to the one already occurred in the recent past. Such an expected appreciation, even if counted on as part of the transmission mechanisms of monetary policy, raises a “fear of (upward) floating”, in a context of global economic slowdown. And;
(c) Given the intensity and pervasiveness of the commodity price shocks in question, the distinction between relative-price adjustments and secondary effects has become hard to demarcate. For instance, a friend of mine called my attention to rising donkey prices in Turkey as a reflection of substitution effects sparked by increased fuel prices.
2. Individual country terms of trade and aggregate income effects
A group of IADB economists, under the guidance of my colleague Santiago Levy, Vice-President of Sectors and Knowledge, has recently made an illustrative simulation of the implications of food and fuel price surges to the real income of individual countries in Latin America and the Caribbean. Assuming away substitution effects – i.e. not considering the response of consumers and producers to price changes – they calculated the effects of world prices on each country’s GDP, given its patterns of exports and imports. The exercise can be seen as an estimative of first order effects, under conditions of unchanged quantities of exports and imports, and indicate an upper bound on the loss for countries negatively impacted or a lower bound on the gain for those positively affected. Besides calling attention to several important points, the exercise highlights how full of consequences can be the impediment of domestic relative price alignments with abroad and the corresponding quantity adjustments.
The results presented in Table 1 take the international price changes of six food commodities (beef, corn, rice, soybean, sugar, and wheat) and oil between January 2006 and March 2008 as permanent, and take the average flows of exports and imports in 2003-2005 as the base for each country.
Notice the following:
1. While the higher international food prices in question tend to generate a positive aggregate effect for 5 economies (Brazil, Argentina, Uruguay, Paraguay, and Guyana), the impact seems to be negative for all the others. The diversity of impacts occurs not only between oil exporters and importers, but also in the case of food.
2. The effects of the oil price shock seem to be even more significant in most of the countries. The severity of impacts makes the external-internal alignment of prices of oil derivatives more difficult and at the same time more relevant.
3. With exceptions, Central America and the Caribbean are areas with significantly high negative impacts of both price shocks.
This simple exercise of simulation illustrates not only the heterogeneity of country situations across the region, but also how the misalignment of prices may make potential net gainers not to avail themselves entirely of opportunities, as well as net losers to extend the negative aggregate impacts over time. The larger and longer the wedge between domestic and global relative prices, the higher (lower) the ultimate losses (gains), as demanded and supplied quantities are not led to change.
3. Bottom line: get both aggregate and relative prices as close to right as possible
If the current oil and food price hikes are not to be fully reverted in the medium term, the least painful policy path is clearly to facilitate adjustments to them. The space for fiscal and/or foreign indebtedness should be primarily used to finance such an adjustment, rather than accommodate and protract it. On the macroeconomic policy front, attention must also be given to ensuring that aggregate price rises are circumscribed to the adjustment of relative prices, avoiding thus the need for future disinflation policies and their asymmetrically higher sacrifice costs.
Of course, particularly in the case of food prices, the impact of domestic aligned prices tends to affect mainly low-income non-food-or-oil-producers in the region. Nonetheless, policies to mitigate such impoverishing impacts should be as focalized on the poor as possible, avoiding the use of scarce fiscal and external debt space for smoothing in a generalized manner. Furthermore, avoiding price wedges between local and global markets will generate incentives for faster quantity adjustments by both local producers and consumers.