Drought-Related Food Inflation Will Feel Bad but Not Disaster for Economy

Economists expect to see higher inflation numbers due to the lack of crops as a result of the drought. Some economists are saying it will take a while to get the full effect of higher prices and according to Diane Swonk of Mesirow Financial, “It’s coming, and it’s going to be in dairy products, eggs, meat.."

By: Patti Domm
Published: Tuesday, 14 Aug 2012

Consumer inflation should show just a tiny pickup in July, even as the Midwest drought raises the prospect of food inflation in months to come.

Economists expect to see an increase of 0.2 percent in the Consumer Price Index, for both headline and core, excluding food and energy. CPI is released Wednesday at 8:30 a.m. ET. In June, consumer prices were flat and the year-over-year change was 1.7 percent.

“It will take a while to feel the full effect,” said Diane Swonk, chief economist at Mesirow Financial. “It’s coming, and it’s going to be in dairy products, eggs, meat, and people are going to be making tradeoffs in the grocery store but it won’t show up in the CPI.”

The drought has resulted in a severely diminished corn crop and a smaller-than-expected soy bean crop this year. It has also led livestock farmers to slaughter more of their herds than normal, to reduce the impact of feed costs.

“I think it will cause a little bit of a rise in food prices. I don’t think it’ll be so dramatic that will drive the headline number significantly higher. Food prices tend not to be as volatile as energy prices,” said Stephen Stanley, chief economist at Pierpont Securities.

Stanley said in a normal year food prices rise 2 to 3 percent, but it’s yet to be seen how much impact the drought will have. Rising food prices are expected to be one the biggest ripples nationally from the drought, which spanned the Midwest and heavily impacted the corn belt. Prices for new crop corn (December futures) have jumped more than 50 percent since June.

“At least initially, you have these cross currents. While the grain crops have been weak, and that means higher prices for products that use corn, there’s this offsetting influence which is ranchers can’t feed livestock so they send more cattle and hogs to slaughter than they normally would, and that causes a dip in meat prices for a time,” he said. Later on, meat prices typically rise as there are fewer animals to bring to market.

Stanley said 2008 was one of the worst of recent years for food inflation, and prices rose 5.8 percent that year. Last year, prices were up 5 percent, and so far, for the first half of this year, prices are up just 1 percent, he said. “We could get a pretty big shock in the second half, and the year would still be alright. You could get a little lingering affect by the winter, but then you move into another crop year,” he said.

Economists say the real danger to the economy would come if the drought extends beyond this year. They also say the expected food inflation should be temporary and a relatively small hit, when compared to energy inflation, for instance. Therefore, it should not be a big concern to the Fed, or affect any plans it may have for further quantitative easing, which is sometimes viewed as potentially inflationary.

Whole Foods [WFM 94.08 0.35 (+0.37%) ] co-CEO Walter Robb said he does not expect a major impact on inflation from the drought, so far. “For the last 18 months, it’s really been disinflationary as prices have moved down,” he said on “Closing Bell.” “It’s just with this recent news and the concerns in the Midwest, with the drought, where I think we’ll see inflation of 2 percent through the year, and then perhaps moving up to 3 to 4 percent in 2013.”

Robb said his high-end grocery chain should not be badly impacted. “Really I don’t think it affects us in the near term both because we have great contracts in place to protect ourselves and because there’s a lag time typically of six to nine months between when those prices increases come at the farm, and when they land with the consumer goods,” he said. “I think you’re going to see movement upward in inflation in 2013, but I think it’s manageable at this point from everything I see.”

Rising food prices may not put much pressure on CPI but the affect will show up in consumption data, as families purchase substitutes in place of higher-cost meats. “Food inflation is not very large, but it is important to people living paycheck to paycheck to put food on the table,” Swonk said.

Swonk said there are major geopolitical implications from the shrinking U.S. corn crop, now expected to total 10.8 billion bushels, down from early forecasts for a bumper 14.8 billion. The Department of Agriculture now predicts ending inventories of 650 million bushels, the lowest level since the 1995/1996 crop.

“We have stocks around the world that are pretty low. It’s got ripple effects that potentially could be multiyear. You’re going to have to catch up on restocking these crops. It adds insult to injury on economies that are dealing with political stability,” she said.

Swonk said CPI could be impacted by rising gasoline prices, up 30 cents a gallon in the past month. Gasoline, impacted by refining issues and rising oil prices, are also getting a slight boost from the cost of ethanol. Ethanol, made of corn, is blended with gasoline and as corn prices rose, it likely added about six cents per gallon to gasoline prices in the last two months. The ethanol industry is the biggest user of the U.S. corn supply, expected this year to require 42 percent of the crop, according to the most recent USDA data released last week.

Stanley said farmers, while individually impacted, may not fare that poorly overall since they have done fairly well in recent years. Also, crops that can be sold will get higher prices.

Dennis Gartman, commodities analyst and editor of the Gartman Letter, said he thinks farmers will come through the drought alright because of insurance. “It’s not a longer term condition. It’s not a devastated Midwest economy,” he said on “Fast Money.”

Deere [DE 75.08 -5.05 (-6.3%) ], which makes tractors and farm equipment, reports earnings Wednesday, and its comments will be watched for any comments on drought impact. “If the banks continue to come in and say we’ll support the system, we’ll make loans to get next year’s crop in and Deere will be fine,” Gartman said.

Besides CPI, there is the Empire state survey at 8:30 a.m. Wednesday. Treasury international capital flows are released at 9 a.m., and industrial production is reported at 9:15 a.m. The National Association of Home Builders survey is released at 10 a.m.

Earnings reports are also expected from Target, Abercrombie and Fitch, and Staples before the opening bell. Cisco, Applied Materials, Limited Brands, NetApp, Agilent and Hot Topic are reporting after the closing bell.

All the platforms of NBC News, including CNBC and CNBC.com, will provide in-depth coverage of the drought and its impact all day Wednesday.

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