Why central bankers will try to look through supply shocks

Central banks' target headline inflation for the most part; there is usually special consideration given to core inflation, which excludes food and energy. This is largely because energy prices can be subject to large and often temporary supply shocks. Often central bankers will try to look through such supply shocks. That may be right when it comes to energy, but it is not right when the supply shock is in food.

There are a number of reasons why the Standard Bank takes this view. One is that food tends to be a much larger part of the CPI basket, hence a change in prices that matches any change in energy prices will have a proportionately bigger impact on the CPI data. A second factor is that, while food price shocks may be slow-moving and smaller than those in energy, they can be longer-lasting, and hence more difficult for central banks to ‘see through’ when setting policy. And a third reason is that consumers’ inflation expectations are likely to be more sensitive to food price inflation than energy; everybody eats, but not everybody drives a car.

“We are making these observations now because it seems that some counties are experiencing, or likely to experience, adverse food supply shocks that could keep inflation more elevated. In particular, we are concerned about the UK and US. The UK has, of course, been in the throes of a food supply shock that dates back to Brexit. But other factors have also come into play, such as adverse climate effects, that have helped push food inflation up to just over 5% (5.1% in August) from as low as 1.3% a year ago”, said Steven Barrow, Head of Standard Bank G10 Strategy.

 In Steven Barrow’s view, this has not just contributed to the rise in headline inflation but also much of the rise in consumers’ inflation expectations. For his sense is that consumers' inflation expectations are very sensitive to food prices, probably more so than any other goods or services. Hence, it matters when food prices are a disproportionately large part of the general inflation picture. It seems that many Bank of England members are attuned to this issue, which is making them resist pressure to vote for rate cuts.

In the US, on the other hand, it seems that all FOMC members are on board with the idea of cutting policy rates, and that’s despite the fact that food price inflation could become a much bigger problem thanks to an adverse supply shock. This supply shock relates to the availability of agricultural workers.

A recent Department of Labour (DOL) report suggested that a huge 42% of agricultural workers are potentially unable to enter the country due to migration restrictions, potentially subject to removal by Immigration and Customs Enforcement (ICE), or likely to just leave the workforce. The DOL sees this as a potentially chronic shortage in a sector where labour intensity is high and labour costs are a significant part of firms’ expenditures. The implication, of course, is that food prices could rise much faster than their current rate of 3.2%. And, given that food is some 13.6% of the CPI, the implications for overall inflation could not just be significant but long-lasting as well, given that it seems unlikely that labour supply into this sector is going to pick-up noticeably. So, unlike an energy price shock that can lift inflation more quickly than a rise in food prices, the latter creates a more insidious increase in prices. This is not just because the supply shock may be longer-lived, but also because inflation expectations can ratchet much higher if basic food prices rise.

“We saw this, for instance, during Biden’s term in office when the price of eggs soared and seemingly became a vote-winner for Trump in the election campaign. But fast-forward to today, and the danger is that rising food prices start to cost the president and the Republican Party support. Unlike the UK, we suspect that the Fed will push on with back-to-back rate cuts this year. That might seem sound, as food inflation at the moment in the US is probably not ringing any alarm bells. But we think that it soon will, and if, as seems likely, the Fed continues to cut, the cost could be that longer-term yields stay higher, just as they have done in the UK as food prices have risen,” emphasized Steven Barrow.