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Why a nervous Fed fears rising food prices

U.S. President Barack Obama views drought-affected corn fields in Missouri Valley, Iowa, on Aug. 13, 2012.

LARRY DOWNING/REUTERS

For the moribund U.S. economy, a severe summer drought is the last thing it needed. An almost-certain spike in food prices will bring out the usual cries that runaway inflation will arrive quicker than a 30-minute pizza delivery.

In the U.S. perception is reality -- and sound monetary policy is going to pay the price.

Only a small portion of the consumer's dollar is spent on food; purchases for consumption at home make up only 7.6 per cent of the average American's budget. Even if we add in restaurant and other outside food purchases (5.1 per cent), we only reach a total of 12.7 per cent of a household's spending. The rise in food prices would have to be particularly high to influence the overall rate of inflation.

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What will increase more than the actual rate of inflation is people's sense of inflation. Since food is purchased frequently and advertised heavily, we notice an increase a rise in food prices more acutely than we would a rise in the price of snow tires or consumer electronics. As such, inflation will be seen as being more of a problem than it actually is.

More worryingly, however, is the fact that the percentage of income spent on food varies greatly by income, with high-income earners allocating 11.7 per cent of their spending on food but low-income earners spending over 16 per cent. Measures of inflation are inherently problematic because they are based on the change of prices of a "representative" basket of goods. But the set of goods purchased by any two consumers is not the same, so your rate of inflation can differ greatly from mine. When food prices rise higher than other prices in the economy, the rate of inflation experienced by the poor is disproportionately high.

Concerns about the overt rise in food prices goes beyond the impact they have on low-income households. They are also likely to have a negative impact on monetary policy.

Despite the Federal Reserve's strict mandate of 2 per cent inflation, expect the U.S. central bank to continue its excessively tight monetary policy. The Federal Reserve will not want to be seen as fueling food price inflation that disproportionately impacts the poor. This is somewhat ironic, as more robust monetary policy is what is needed to solve the U.S.'s chronic unemployment problem.

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About the Author

Mike Moffatt is an Assistant Professor in the Business, Economics and Public Policy (BEPP) group at the Richard Ivey School of Business – Western University. Mike also does private sector consulting for the chemical industry. More

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