Inflation and interest rates: El Nino will brew up potent new economic storm
Last year, New Delhi banned broken rice exports, imposed on other grades after below-average monsoon
MELBOURNE (Reuters Breakingviews) – Just when you thought it was safe to hope interest rates might soon peak, along comes more bad news. It looks likely that the El Nino weather phenomenon has returned, according to both the US National Oceanographic and Atmospheric Administration and the Australian Bureau of Meteorology.
Its appearance usually results in, or exacerbates, floods, heatwaves, water scarcity and wildfires, especially in the southern hemisphere. The damage these inflict on crops and infrastructure is inflationary, putting pressure on central banks to tighten monetary policy. If climate change makes such events stronger and more frequent, supply shocks will become embedded.
This year’s El Nino is shaping up to be a record breaker. The phenomenon is created when the surface temperature of the eastern and central Pacific Ocean is at least 0.5 degrees Celsius warmer than average, weakening or reversing the flow of the trade winds. The strongest one to date was in 2016, when the sea surface temperature hit 2.6 degrees above average; that level could reach 3.2 degrees Celsius this November, Australian meteorology’s finest revealed a couple of weeks ago.
So far, traders have focused on some of the commodities most likely to be affected. Rice futures hit an almost 15-year peak in June, excluding a 2020 pandemic spike. India, Thailand and Vietnam, the three largest exporters of this staple, have already this year experienced record or near-record high temperatures and tend to suffer from hotter, drier weather due to El Nino.
In anticipation of water shortages, Thai authorities in May asked farmers to plant just one, rather than two, crops this year. Vietnam has already been under drought conditions, which has also affected yields from its robusta coffee trees. The country is the top producer and exporter of the bean which is used for instant coffee as well as making up around 15 per cent of Italian espresso blends. Last week, the robusta futures contract reached its highest price since being introduced in 2008, having risen 60% this year.
By one reckoning, a single El Nino event might seem manageable. It can push up the price of oil almost 14pc and non-fuel commodities by more than 5pc within a year of an event, the International Monetary Fund calculated in 2015. But the biggest increases in overall inflation over a 12-month period were only around 1 percentage point and limited to a handful of the most exposed countries like Brazil, Indonesia and Mexico, the IMF analysts concluded.
Researchers at the University of Dartmouth this year extended the timeframe and estimated that the 1998 El Nino, the second strongest on record, caused global economic losses of $5.7 trillion, in 2017 dollars, over five years.
Much has changed since then. First, the world is warmer: the eight years since the IMF paper have also been the world’s eight hottest on record – even with cooler Pacific Ocean temperatures since 2020 giving rise to El Nino’s opposite, La Nina.
On the one hand, global warming has exacerbated aridification in parts of Europe, China, Southeast Asia and the United States, some of which El Nino may yet worsen. On the other hand, it creates the conditions for heavier deluges because for every 1-degree Celsius increase in its temperature, the air can hold 7pc more water. That means crops which usually benefit where El Nino brings wetter conditions – such as US soybeans, which have been hit hard by lack of rain – now face a greater risk of being swamped.
Oceania felt some of those effects during La Nina. A second consecutive year of floods in Australia contributed to food inflation rising at an annualised rate of 9pc in the three months to September 2022, its highest level since 2006, per Rabobank. Meanwhile, New Zealand’s fruit and vegetable price index spiked 22% year-on-year in March, a month after cyclone Gabrielle hit. Heavy downpours – and frost - also depleted harvests of arabica coffee in top exporter Brazil and other Latin American countries in 2021 and 2022, pushing the futures price up to a decade high in February last year. That also helped spur increased demand for robusta beans.
The direct impact of El Nino- and La Nina-affected weather on sowing, growing and harvesting is not the only economic consideration. Infrastructure can be damaged or destroyed: early last year, for example, floods swept away a 30-kilometre stretch of the only rail line that transported food to Western Australia.
And sugar futures may in part have hit an almost 12-year high in June due to concerns that excess humidity could bring a repeat of the 60pc increase in work stoppages that beset Brazil’s cane fields in 2016, per Barclays. But there was another reason: a combination of a disappointing crop last season and the prospect of El Nino causing water shortages prompted India, the world’s second-largest producer, to effectively ban exports until next year.
There are other recent examples of protectionism under the guise of national food security. Last year, New Delhi banned exports of what’s called broken rice and imposed a 20pc levy on other grades heading overseas after below-average monsoons, even though its stock levels were decent, notes Barclays. The restrictions are still mostly in place. In April last year, meanwhile, Indonesia temporarily banned the export of palm oil – used in all manner of foodstuffs and other goods – as domestic cooking oil prices surged.
It’s not hard to imagine the country, which accounts for more than half of all palm oil exports, using El Nino to justify reimposing the embargo, or other producers of agricultural goods taking similar actions.
All these uncertainties are a store of potential supply shocks capable of driving up prices over the next year alone. Rising temperatures due to climate change will make them more endemic; the World Meteorological Organisation in May declared there’s a 98pc chance that the next five years will be the hottest period on record thanks to the combination of greenhouse gas emissions and El Nino.
After struggling to cope with an inflation storm caused by the pandemic and the war in Ukraine, policymakers have a potent new economic hurricane coming their way.