Canadian Public Policy

Food Price Increases and InflationAuthor(s): Norman CameronSource: Canadian Public Policy / Analyse de Politiques, Vol. 6, No. 2 (Spring, 1980), pp. 300-306Published by: University of Toronto Press on behalf of Canadian Public PolicyStable URL: http://www.jstor.org/stable/3549999 .

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Food Price Increases and Inflation

NORMAN CAMERON*/Department of Economics, The University of Manitoba

In the last decade it has become obvious to all who eat that food price increases have a lot to do with the inflation of our Consumer Price Index (CPI). This is reflected, among other ways, in the practice of reporting separately both the CPI increase and the increase in the 'CPI ex- cluding food.' Even the latter has been increasing rapidly in the 1970s, however, leaving the impression that food price inflation is only a small part of the story and diverting attention elsewhere. In this paper I try to account for the indirect as well as the direct effects of those

exogenous food price increases which pull the CPI up or down. A simple but plausible simu- lation of our economy without such food price increases produces the conclusion that food price increases in fact account directly and indirectly for most of the surge of inflation we have had in the 1970s, and that at least we should devote much more attention than we have to the size and timing of one-shot cost increases caused by government policy changes.

Food prices are singled out for two reasons. First, they represent a large proportion of the CPI and are observed weekly by shoppers.' Second, they are to an unusual extent out- side our domestic wage-price spiral: on the cost side, the share of the direct domestic labour

input in food production and processing is only two-thirds of that for manufacturing, and

supply is subject to vagaries of weather and agricultural cycles; on the demand side, many of the primary agricultural commodities are traded on world markets, and their price is deter- mined abroad as much as at home.2 Even the exchange rates which convert world grain mar- ket prices to C$ prices are sources of disturbance, since they are always influenced by our economic performance relative to that of our trading partners and rival capital markets.

Figure 1 shows our inflationary experience since 1954, and shows up clearly the relative volatility of food prices in the 1970s. What this note does is to compare the historical time

* The author would like to thank Richard Lobdell, Henry Rempel and referees of this journal for helpful comments.

1 The share of food is 21.5% in the 1974 basket recently adopted, and 24.8% in the previous 1967 basket used since 1973 (Statistics Canada, 1978:85).

2 Smith (1975:9). The large domestic labour input into food-processing is not important to this exercise, because it is not the source of volatility of food prices relative to other prices. Wage costs in the food- processing industry respond to many of the same forces as in other sectors, as one would expect, and Smith found, for instance, that unit labour costs had only a small influence on food prices in the years 1968-74 (p.20).

CANADIAN PUBLIC POLICY - ANALYSE DE POLITIQUES, VI:2

spring/printemps 1980 Printed in Canada/Imprim6 au Canada

0317-0861/80/0014-0300 $1.50 ? 1980 Canadian Public Policy - Analyse de Politiques

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16

Figure 1 Inflation, 1953-79

14 Legend - =food prices

- CPI

12 = CPI excl. food

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302 / Norman Cameron

path of inflation of the CPI in Figure 1 with what it would have been if the rate of inflation of food prices (Pf) had been the same as the rate of inflation of non-food prices

(Pnf). To find this simulated path the effects of 'extra' food price inflation (i.e., Pf - Pnf) must

be removed from the average inflation rate (P) for each year. These effects consist of the di-

rect effect of (Pf - Pnf) on P, which is due to food prices being a component of the CPI in

Canada, and all indirect effects of (Pf - Pnf) on other determinants of our average inflation rate. The direct effects are already removed in the time series data for inflation of the CPI excluding food in Figure 1, so only the indirect effects present any difficulty.

If food price increases are reset to the average rate for non-food prices and nothing else that is exogenous is varied from its historical settings over the 1954-79 period, then estima- tion of indirect effects will require specification of a full model of the economy, and the an- swer will reflect mainly the theoretical assumptions of the model specified. For instance, in the simplest monetarist model in which inflation is purely a monetary phenomenon, equal at all times to the difference between the rates of growth of money supply and real output, a decrease in food price inflation with unchanged money supply growth would cause only a

temporary fall in average inflation, accompanied by an equally temporary rise in output growth. More complicated assumptions about the working of the economy would generally produce more complicated changes in average inflation, as one would expect.3

I have side-stepped this quagmire of theoretical conflict by recognizing that monetary and fiscal policy are far from independent of the rate of inflation at the time. In particular, I as- sume that if inflation had been different, government policy would have been different in

just such a way as to leave unchanged both the relative degree of monetary ease or tightness and the unemployment rate.4 In the very simple monetarist model referred to above, this would imply that whenever removal of (Pf - Pnf) directly lowers P by 1 per cent the money supply would also grow 1 per cent less in that and all subsequent years, to 'validate' the low- er inflation rate.

This assumption allows us to ignore the effects of unemployment, unused capacity, and

monetary policy on the rate of inflation: whatever the effects, they are identical in both the historical time path and the simulated time path. The one important variable left is the ex- pected rate of inflation. Here I assume that (a) any change in actual inflation has an equal ef- fect on expected inflation, (b) any change in expected inflation has an equal effect on actual

inflation, at any fixed level of unemployment, through effects on the bargaining position of

participants in domestic factor markets, and (c) this two-step process takes a full year to have effect. The lag can be due to lags in adjusting expectations or in acting on revised ex-

pectations; the choice does not matter here.5 With these assumptions, a direct impact of 1 per cent on average inflation in year 1 has an

3 See de Bever et al. (1979) for this approach. 4 For discussion of what this assumption might involve under rival sets of Keynesian or Monetarist assump-

tions, see Burbidge (1979). Where the Bank of Canada pursues a credit conditions approach, or even a monetary growth target set just below the expected growth rate of nominal income, this assumption will be very plausible indeed. Relative price and sectoral income distribution effects are discussed by Burbidge but ignored here as second-order effects.

5 On this, see Phelps and Taylor (1977), Fischer (1977), Sargent and Wallace (1976), Barro (1976), Gordon (1976). It could even be due to a bargaining strategy of catching up on past inflation, rather than keeping up on expected future inflation.

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Food price increases and inflation / 303

indirect effect of 1 per cent in year 2, via changes in inflationary expectations and unit fac- tor costs. This in turn has the same effect in year 3, and so on. The indirect effect of extra food price inflation in any year is therefore a permanent rise in inflation in all subsequent years, by exactly the amount of the direct effect. The direct effect in any year is of course the difference between the inflation rates of the CPI and of the CPI excluding food shown in Figure 1.

To remove both effects and find the simulated path of price inflation, one therefore de- ducts from the historical inflation rates the cumulative sum (from 1954 to that point) of dif- ferences between inflation of the CPI and of the CPI excluding food.6 This simulated path is shown along with the actual time path in Figure 2, traced around the diagram space previ- ously used to depict Phillips curves and unemployment-inflation trade-offs.7

Both series have the same unemployment level for any one year, since I have assumed a particular set of adjustments of monetary and fiscal policy just sufficient to leave unemploy- ment rates unaffected. The inflation values are dramatically different between historical and simulated paths, however. The differences suggest that our inflationary experience from 1954 - 60 would have been substantially worse without the downward pull of sharply falling food prices in 1953, and our inflationary surge in the 1970s would have been only half as large.8 In the 196 0s our inflation rate would have been higher mainly because of a higher underlying level of inflationary expectations inherited from the 1950s. The 1970s would therefore have started from a higher level as well. With food price effects removed, the rapid 4.8 per cent acceleration of 1972-73 is cut to only 1 per cent, mostly in 1972. The acceleration of 1974 and the deceleration of 1976 are likewise cut in half. The stubborn persistence of high infla- tion on into 1978 and 1979 is removed, and instead the simulated path is consistent with a substantial damping effect from relatively high levels of unemployment.

In this respect the simulated path more clearly follows the kind of clockwise cycle which McCracken et al. (1977:106) and Lipsey (1960) observed for western industrial countries, and which the wage-price models in modern macroeconomics texts tend to generate over the

6 Algebraically, t-5 3

sim,t t = (t-i nf,t-i), t= 54,....79

i=O

where Psim, P and Pnf are the simulated, historical CPI, and the historical non-food price inflation rates.

Alternatively, one can express that as t-53 P sim,t =

lt"f I ( f,t-i

"nf,t-i)' i=O where Pf is the food price inflation rate and f is the weight of food prices in the CPI. This presentation as- sumes that cost increases of imported components change in line with cost increases of domestic compo- nents, through adjustments of the exchange rate (between historical and simulated paths) in line with relative changes in purchasing power of the domestic currency. If this is not assumed, then the indirect effect decays over time at a rate (m) equal to the share of unchanging import component costs in the CPI excluding food, and the simulated inflation rate becomes

t-53

Psim, t t (t-i- nf,t-i) (l-m)i, t= 54,....79 i=0 7 The unemployment series for males 25-44 is used, to minimize effects of changing unemployment insur-

ance rules and changing labour force composition (see Lazar, 1978). The levels since 1975 are the levels for all males over 25, plus an ad hoc adjustment by the author of 0.9 per cent. See McCracken et al. (1977: 106) for similar presentations for all OECD countries.

8 If one ignores the 1953 food price drop as simply a correction of still earlier price increases, the entire simulation path drops by 1.4 per cent. The 1979 estimate would then be 2.9 instead of 4.3 per cent.

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304 / Norman Cameron

12

74 [ 1 75

10I I 10 79 est.

I Actual path I /

87- 74 / S 77

73 75

69 77

6

6961 4 m66 n , 79 est. 58

2

56< 64

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61

S o, 54

I ! I II I 3 4 5 6 7 8

Unemployment (%) males 25-44

Figure 2 Actual and simulated inflation and unemployment 1954-79

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Food price increases and inflation / 305

short run of a decade or so in response to disturbances (Dornbusch and Fischer (1978) and Sydor et al. (1979:353 ff.)). Indeed, by 1979 the simulated inflation rate has responded to the medicine of high unemployment (or whatever else it stands for) well enough that it is hard to believe inflation would still be the major concern of stabilization policy.

CAVEATS AND POLICY IMPLICATIONS

This simulation of a world without extra food price inflation has been very simple, requiring little more than the back of an envelope. It has not attempted or succeeded even in explaining all of the irregularities in an underlying stable, smooth clockwise path around the space in Figure 2, if such a stable cycle even exists. This is not surprising, since little mention has been made of such relevant items as the exchange rate, foreign prices, and monetary growth rates. It is intended that whatever influence these factors have had on non-food prices should re- main in the simulated time path as well.

The simulated path is only one of many possible paths, each based on different assumptions about the speed and size of the indirect effect via inflationary expectations. Interested readers can use the back of their own envelope to re-calculate their own series with the raw data from Figure 1.

The exercise is only in part a wishful look at history as it might have been. There are some policy implications which this analysis brings out. First, the simulated path is one step nearer to a picture of whatever the purely domestic inflation cycle is. If the picture in Figure 2 is accurate, then the aspect of such a cycle which stands out is how long it takes: about a full decade, if allowed to proceed full circle. High and low unemployment are associated with deceleration and acceleration respectively, but each process alone can take as long as the average term of a parliament. In a body politic in which high unemployment levels are po- litically dangerous, it is hard to see the medicine of restraint and high unemployment being administered for the required amount of time. On the other hand, for those who inferred from Figure 1 that unemployment and unused capacity have had little or no effect on infla- tion in the 1970s, there is more hope than before.

Second, this puts flesh on the bones of the frequent claims by past finance ministers that if only we would recognize one-shot exogenous cost increases for what they are, and not build them into our wage and profit demands for the future, we would not suffer such per- manent increases in our inflation rate. All of the indirect effects which have been removed from history to give the simulated path in Figure 2 are the result of ignoring such advice. Since we cannot avoid all exogenous cost increases, more attention could be given to methods of getting the public to accept such claims. In particular it would help if there was even a clear differentiation between exogenous and endogenous sources of inflation, so that the public could differentiate accurately between one-shot increases and those likely to recur with continued domestic inflation. The exchange rate as a source of cost increases is a case in point: many past speeches have implied that it is exogenous, even when it floats.

Third, some exogenous cost increases can be avoided, and when the benefit is a perm- nently lower inflation rate with no increase in unemployment, the prospect may be attractive to governments. Two-price schemes such as we have had in the past for wheat flour, and such as we now have for oil, are a means of at least postponing exogenous cost shocks.9 If the

9 This assumes that the taxes necessary to pay any subsidies required are not viewed as costs themselves. The oil price scheme satisfies this criterion at most only to the extent the subsidies are not paid out of indirect taxes.

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306 / Norman Cameron

main welfare gain comes from properly anticipating inflation, rather than from actually elimi- nating it, such ability to postpone and control the timing of exogenously generated cost in- creases is indeed valuable. Further, some small part of the exogenous food price increases are the result of government policies, such as the setting up of producer marketing boards in the 1970s. The Food Prices Review Board was quite clear in its condemnation of this policy as excessively inflationary: 'It is now clear that throughout 1973- 75 producer marketing boards in Canada contributed substantially to increased food prices. Portions of those increases were unwarranted in the food price circumstances pertaining to that period' (1976:45) What was not clear at the time was that with a set of stabilization policies which accommo- date all or almost all of the actual rate of inflation, the full inflationary impact is not just one-shot, but either permanent or slow to disappear. We would still be benefitting from the Liberal government having taken more of the FPRB's advice.

REFERENCES

Barro, R.J. (1976) 'Rational Expectations and the Role of Monetary Policy, Journal of Monetary Economics, 2, January.

Burbidge, John B. (1979) 'Two-Sector Models of Inflation and Recession' (McMaster Uni- versity, mimeo)

de Bever, L., et al. (1979) 'Dynamic Properties of Four Canadian Macroeconomic Models: A Collaborative Research Project,' Canadian Journal of Economics, 12, May.

Dornbusch, Rudiger and Stanley Fischer (1978) Macroeconomics (McGraw-Hill) Fischer, Stanley (1977) 'Long-term Contracts, Rational Expectations, and the Optimal Mon-

ey Supply Rule, Journal of Political Economy, 85, February. Food Prices Review Board (1976) Final Report: Telling It like It Is. Gordon, R.J. (1976) 'Recent Developments in the Theory of Inflation and Unemployment,'

Journal of Monetary Economics, 2, April. Lazar, Fred (1978) 'The Impact of the 1971 Unemployment Insurance Revisions on Unem-

ployment Rates: Another Look,' Canadian Journal ofEconomics, 11:559-569. Lipsey, Richard G. (1960) 'The Relation Between Unemployment and the Rate of Change of

Money Wage Rates in the United Kingdom, 1862-1957: A Further Analysis,'Economica, Feb., 1-31.

McCracken, Paul et al. (1977) Towards Full Employment and Price Stability (OECD) Phelps, Edmund S. and John B. Taylor (1977) 'Stabilizing Powers of Monetary Policy Under

Rational Expectations,' Journal of Political Economy, 85, February. Sargent, T.J. and Neil Wallace (1976) 'Rational Expectations and the Theory of Economic

Policy,' Journal of Monetary Economics, 2, April. Smith, Douglas A. (1975) Direct Labour Costs in the Food Processing Industries in Canada

(Food Prices Review Board) Statistics Canada (1978) The Consumer Price Index: Revision Based on 1974 Expenditures;

Concepts and Procedures (Cat. 62-546) Sydor, L.P., E.K. Grant, J.N. Benson, D.A.L. Auld (1979) Macroeconomic Foundations:

An Intermediate Text (Methuen)

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