Implications of Summer Drought

The US main agriculture region is experiencing the worst drought in more than half a century.  Corn and soybean prices are being driven through the 2007-2008 highs to new record levels.  

The USDA publishes new food price forecasts on the 25th of each month.   There is no prize for guessing the direction of prices in next week's report.  In June when corn was under $6 (now above $8) a bushel, the USDA expected a 2.5-3.5% increase in food prices, after about 4.8% increase last year and a 2.8% average annual increase over the past 20 years.  

The latest US Department of Agriculture estimates that 31% of the corn crop is in good to excellent condition compared with 40% a week ago.  The soybean crop is not faring much better with 34% of the crop considered good to excellent compared with 40% previously. 

Many consumers and investors do not fully appreciate the extent to which the modern economy is based on corn.  It is not simply used as a substitute for gasoline and animal feed, but reports indicate a full three quarters of the products in a supermarket use corn in some form.

The roughly 50% increase in corn prices translates to a 1% rise in shopping bills according to economists at the USDA.  The effect on specific food prices vary.   It takes, for example, about 2.6 pound of corn to produce a pound of beef.  That means that the increase in corn prices may see a 4-5% increase in beef prices.  The increase in the price of corn (chicken feed) will boost egg prices 1-2% and a 2-3% increase in dairy prices.   

Many will suspect that higher corn and soybean prices will translate into higher farm income, but the situation is more complicated.    There is an analogy here with the price of consumer goods and imports.  It turns out that for some imported products, more than half of the cost to the US consumer does not come from the importation of the item, but the locally incurred costs related to storage, shipment and marketing.  The same is true of farmers and food prices.  

The USDA estimates that only about 16 cents of each dollar spent on food goes to farmers.  The rest goes to labor, packing, transportation and advertisement.  Food processors, who turn crops into cereals and oil and other products get about 32 cents from the dollar spent on food.  Food service companies get about 47 cents of each dollar spent on food.  

Farmers, according to reports, get about 7% of the retail price for cereals and baked goods.  Dairy and cattle farmers do a bit better, getting 37% of the retail price of butter and 46% of the price of milk, a little more than 50% of the retail beef price and about a third of the price of pork. 

In addition, US agricultural production is also energy intensive (from fertilizer and pesticides to farm equipment and transportation).  About 3.5% of the the money spent on food goes to energy.   Since the end of June, WTI is up almost 20%. 

Food and beverages (many use corn in some form for sweetener) typically account for 15% of the typically American consumption.  The Federal Reserve tends to give more weight to the measures of inflation that exclude the price of food and energy.  However, the rise of food and energy prices will cut into the purchasing power of households.   As we saw earlier this week, with the poor retail sales report, that the US consumer was vulnerable even prior to the latest increase in food prices and the recovery in energy prices.

Other countries, especially among the emerging markets, typically have a greater weight for foodstuff in their inflation measures and typically look at headline instead of core inflation measures.   Previously the price environment seemed more benign.Facing global headwinds and higher food and energy prices makes rate decisions more difficult to many.