Danger growing that slump in food prices will reverse

Steep falls in asset prices, millions of jobs lost, global recession - there isn't much good to have come out of the financial crisis that gripped the world last year.

One undoubted benefit, however, has been the plunge in food prices.

As recently as April last year, governments and supranational bodies like the United Nations were in a panic about the surging cost of staple foods.

The first chart below shows the relative price performance of rice and wheat futures traded on the Chicago Board of Trade. Both had risen about 100 per cent over the previous year.

And it was not just rice and wheat. The prices of pork, poultry, dairy products, soyabeans and sugar were all up steeply. As a result, annual food price inflation on the mainland hit a high of 23 per cent.

The reasons for the increase were many and varied. Blue ear disease in pigs was blamed for the rise in pork prices in China. Water shortages in Australia contributed to pushing up rice prices.

But one common theme underpinning the rise in many food prices, although the mechanisms were not always either direct or obvious, was financial speculation.

Central bank interest rate cuts in late 2007 in response to the outbreak of the credit crisis released a wave of cheap liquidity into global financial markets. With traditional asset classes like stocks and property looking vulnerable, leveraged investors pumped a lot of that liquidity into commodities in the expectation that rising demand from China would support prices.

The favourite trade was to go long oil, and the price of crude shot up 150 per cent over the 18 months to July 2008.

Farming is an energy-intensive business, and the increase not only pushed up the price of fuel but of petroleum-based fertilisers, too. Add to that the increased cost of transporting produce to market, and food prices began to rise steeply.

To make things worse, the run-up in the oil price spurred commercial interest in bio-fuels, which meant increased competition with food crops for land, further pushing up prices, especially of grains. That made livestock feed more expensive, driving up meat and dairy prices.

The move soon acquired a momentum all its own, as more and more speculators jumped on the trend of rising food prices, driving prices still higher. Unnerved, several governments slapped export controls on staple foods, which only encouraged widespread hoarding, exacerbating the increases.

The bubble burst, as bubbles must. As the trend reversed, speculators fled the market. In one telling example, the number of speculative open positions in Chicago-traded corn futures fell by half between March 2008 and March 2009. Food prices tumbled around the world. In China, food price inflation not only abated but even turned negative.

The relief was welcome, but there is a danger it may prove fleeting. With the oil price now trading at double the lows of six months ago, farmers' fuel costs are rising once more, and interest in bio-fuels is growing again.

Meanwhile, fears are growing that an El Nino climate pattern will develop in the second half of the year, raising the threat of water shortages in important crop-growing regions.

Yesterday, the Organisation for Economic Co-operation and Development and the UN's Food and Agriculture Organisation warned that overall food prices are likely to climb 10 to 20 per cent on top of inflation over the next 10 years compared with pre-2007 levels, with some staple foods rising much more.

That's ominous. With plenty of liquidity sloshing around, investment advisers are once again recommending agricultural commodities to their clients.

It seems one of the few benefits people have enjoyed from the financial crisis may turn out to be disappointingly short-lived.