University Of Balamand Economics and Capital Markets Research Center A Banque Libano-Française Partnered Initiative

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1 University Of Balamand Economics and Capital Markets Research Center A Banque Libano-Française Partnered Initiative Special Report February 5 0 THE IMPACT OF THE ONGOING OIL AND FOOD SHOCKS ON MONETARY POLICY Inflation rates in the UK, the US and the euro zone rose markedly in the latest months, increasing the nervousness of the hawks of the central banks of these countries, who are now worried about an inflationary spiral that may hinder the credibility of their institutions. In this paper, we will analyze the factors that induced this increase in inflation, in order to conclude about the adequate answer of these central banks. Let us begin by presenting the recent trend of inflation: - Total inflation in the US rose from the recent low.05% in June 00 to.6% in January 0. US: CPI (YOY) Total inflation in the euro zone rose from the recent low 9% in August 00 to.6% in January 0. - Total inflation in Britain rose from the recent low % in September 00 to % in January 0. UK: CPI (YOY).00. Despite this big increase of total inflation, core inflation rates in US and in the euro zone are still low (0.9% and.% respectively). US: CORE CPI (YOY) EUROZONE: HCPI (YOY) EUROZONE: CORE HCPI (YOY)

2 As In the UK, core inflation increased markedly and is flirting with the level of %. UK prices were affected by the increase of the VAT rate from 7.5% to 0%. UK: CPI FOOD (YOY) UK: CORE CPI (YOY).97.5 Source: EUROSTAT-ECMRC 0.5. We can see that this acceleration of total inflation is mainly due to the two volatile components which are food and energy. The following charts show us the major increase of food prices and energy prices in the recent months. US: CPI FOOD (YOY) US: CPI ENERGY (YOY) EUROZONE: CPI ENERGY (YOY) Source: BLS-ECMRC EUROZONE: CPI FOOD (YOY) Source: EUROSTAT-ECMRC What are the factors that explain these increases? Source: EUROSTAT-ECMRC Oil prices reached.97$/barrel in February 0.

3 OIL PRICE (BRENT) Price USD Bbl CEREAL PRICE INDEX The major factor that can explain this increase is the uncertainty about the supply of oil. Political tensions in different Middle East countries and the risk of an escalation of violence in this region is surely maintaining upward pressures on oil prices. The robustness of international demand is also supporting this increase. Food prices also increased markedly in the recent period. FOOD PRICE INDEX MEAT PRICE INDEX Source: FAO-ECMRC Source: FAO-ECMRC 0 0. Source: FAO-ECMRC A lot of factors can explain these movements: Reduced production due to bad weather. Climate change has an important effect on production and supply causing an increase in food prices. Australia suffered from severe floods in January 0 affecting the production of wheat and sugar in Queensland. Russia suffered from harsh droughts also affecting the production of wheat. Climate change is actually due to global warming and it is going to be more severe in the coming years. Export restrictions and panic buying. Due to bad weather shocks, restrictions on export have been put and consumers were afraid resulting in panic buying. After the drought in Russia, an export ban was imposed and resulted also in panic buying. Increased demand for food and biofuels. Due to the increase in oil prices, consumers are turning towards biofuels as an alternative for oil. Since there is a higher demand on this alternative, more land, water and capital are directed towards this production contributing in more trade-offs between food and fuel due to the fact that more grains are used for the production of bio-fuels instead of the production of food resulting in an increase in its prices. Furthermore, a lot of subsidies were given to the production of ethanol which pushed a lot of farmers away from the production of crops.

4 intensify in the coming years due to the fact that population will be growing faster. Changes in eating habits especially in China. Higher economic growth in China and hence a higher purchasing power are increasing demand on food especially on meat. This will also lead to a higher demand on food since meat requires a higher amount of water and grain. All in all, we can see that this inflationary situation is mainly cost-push rather than demand-pull inflation. The following charts confirm this conclusion. These charts show the existence of spare capacities in the US, the UK and the euro zone. The existence of these capacities should limit the materialization of a demandpull inflation. US: CAPACITY UTILIZATION RATE 8 Speculation. Speculators, seeking for higher returns, are buying commodity assets to make profit because of the high uncertainties on other markets. High liquidity in the market because of the quantitative easing policies of many countries and especially in the US. The increase in oil prices. The rise in oil prices resulted in an increase in prices of fertilizers and pesticides. It also affected the cost of transporting food from the farms to local markets as well as the cost of exporting these products. The increase in population growth. This leads to higher demand for food. It is expected that this factor will EUROZONE: CAPACITY UTILIZATION RATE

5 UK: CAPACITY UTILIZATION RATE The major risk that can be advanced by central bankers is related to what they call the second round effects: higher wages and the increase of the price of other products. Concerning the risk of higher wages, we do not think that with the high level of unemployment and with globalization this risk will materialize. 5 US: LABOR WAGES AND SALARIES (YOY) US: UNEMPLOYMENT RATE EUROZONE: LABOR COST HOURLY WAGES (YOY).5 EUROZONE: UNEMPLOYMENT RATE UK: UNEMPLOYMENT RATE UK: AVERAGE WEEKLY EARNINGS (YOY) Concerning the risk of higher prices of other products, we think that the weak demand in these countries and fierce competition should limit this risk. The major increase may be in transportation prices. 5

6 US: CONSUMER SPENDING EUROZONE: RETAIL SALES UK: RETAIL SALES 8.8T 8.T 8T 7.6T What can be the reaction of the central banks of these countries? The cost-push inflation is a big challenge for central bankers. In fact, the oil and food shocks are going to increase total inflation which will harm the objective of price stability of these central banks. In the same time, these shocks reduce the purchasing power of citizens of these countries increasing the odds of a major slowdown of the economies of these countries and even the odds of a new recession. The scenario that we may encounter due to these shocks is stagflation Central banks with a unique objective which is price stability like the ECB and the BoE will be tempted to tighten their monetary policy in the future. In UK, three hawkish members asked for a rate hike in the latest meeting according to the minutes of this meeting. Other members were considering this option. In the euro zone, the official communication was more hawkish in the latest months. This hawkish communication is expected to intensify in the next period. It is important to remember that the ECB voted for a rate hike in July 008 despite the bad economic and financial environment that was prevailing. Its decision was justified by the high risk of inflation which was cost-push inflation and not a demand-pull inflation. Hawks of the ECB will increase their pressures to do the same in the next month in order to combat inflation. The Federal Reserve, a central bank that has a dual mandate which is price stability and low level of unemployment, should be less aggressive than the ECB and the BoE. We think that the Fed may opt for a statu-quo in the near future, taking its time in order to analyze the impact of these shocks on the economy before altering its monetary strategy. All in all, recent increases in oil and food prices are going to complicate the international economic situation hurting growth and boosting inflation. Any tightening in monetary policy, a scenario that is probable in UK and in the euro zone, should increase the odds of a new recession. Paul Douaihy Director Economics and Capital Markets Research Center Nour Attieh Junior Economist Economics and Capital Markets Research Center 6