Hamish McRae: We will have to beat inflation the hard way

Inflation is back, in everything but house prices that is. One of the many dreadful aspects of the tragedy in Burma is that getting food supplies to the region is vastly more difficult that it would have been a year ago. This is not just because global food prices are higher – up some 50 per cent year on year according to the United Nations – but obtaining substantial quantities of even such basics as rice is sometimes impossible.

In the West we see the impact of rising food, energy and raw material prices at the pumps and in the supermarkets. This is dragging up prices more generally and curbing the scope the central banks have to cut interest rates. But it is not, at least not yet, a social catastrophe.

True, the price of things we have to buy is rising much faster than the things it would be nice to buy. So the price of fuel is rising faster than the price of a TV or a suit. But food accounts for only just over 10 per cent of the UK consumer price index; by contrast in India it is some 60 per cent and I understand that in rural villages in India more than 80 per cent of family incomes is now spent on food. Food inflation there is a social and human disaster. We have had oil shocks before but we have not, for a generation at least, had a food shock. Indeed for the past half century, despite the steady rise in the world's population, the long-term trend in food prices has been down. What has gone wrong?

Well, we all know that it is a mix of factors; the hard bit is ascribing the level of importance to each. One immediate and recent blow has come from the switch from food crops to bio-fuel crops, with incentives to do so in both the European Union and the United States. In the US this year one-third of the maize crop will go to bio-fuel. The EU wants to double bio-fuel use by 2020. Such policies may be well-meaning, but they have had a pretty disastrous impact. Another recent global shift has hit food prices: the rise in the oil price. That affects everything: transporting food and fodder, fuel for tractors of course, but also the cost of fertilizer, energy for drying grain and so on.

An equally obvious factor is the rising demand for meat from China and other parts of Asia. Animals are inefficient converters of calories: you get more calories by eating the grain rather than feeding to a chicken or a pig and eating the creature. As Chinese people have become richer it has followed the same path as we did a century and more ago, increasing the proportion of meat in their diets and reducing the amount of root crops.

Urbanisation makes matters worse. It is an arbitrary calculation but humankind has recently tipped from having more people living on the land to more people living in cities. Cities are built on plains and near water; as they expand they gobble up agricultural land. So a rising world population hits the food/people balance in two ways: more people and less arable land to feed them. Longer term, a rising population, using more fossil fuels, will put more pressure on the planet so it is hard to see a light at the end of the tunnel.

This is by no means a new phenomenon but up to now the world has managed to cope. The rise in crop yields has for a generation run just ahead of rising populations – the so-called green revolution. But during the past few years that rise seems to have slowed. It is not quite clear why this should have happened: a natural plateau in yields or degradation of crop land, or something else? At any rate it inevitably raises questions about genetically modified foods and whether these could become the next green revolution or whether they have such disadvantages that they cause more problems than they solve. The big point here is that there is no obvious quick fix. Prices may shade back in the coming months; indeed there is a good chance they will. But it is hard to see cheap food returning.

That will affect the world in many ways, some of which are impossible to predict. You cannot say now where the social pressures will lead. But what you can say is that high food and energy prices will drive up global inflation as they feed through the world economy. There are first-stage direct effects and we see these now. They will be followed by second-stage effects that are only starting to come through.

One of the features of the past decade has been low inflation in traded goods. Here in the UK the falling price of most goods helped offset the rising price of most services. So we have had low inflation and a steadily rising standard of living. We have been buying cheap goods from abroad and selling expensive services in return. Much the same has happened throughout the developed world. Now we can no longer rely on cheap imports, or at least not the same extent. Wages in China and India are rising by 10 per cent or more a year in response to higher food and fuel prices. That is reflected in the price of globally-traded manufactured goods.

This is not to say that we are heading back to the dreadful 1970s when inflation was in double digits. It is simply that we have benefited from uniquely favourable circumstances that have now come to an end. Holding down inflation will have to be done the hard way: by restricting demand rather than buying cheap goods from abroad.

This is not just a British problem; all developed countries face a similar squeeze. The problems of the rich world are in any case much more manageable that those of poorer countries for the reasons noted above. But rising global inflation in food and fuel will hold back growth in our living standards for the next couple of years at least, maybe longer.

As a result it is reasonable to expect the downswing of this global economic cycle to last rather longer than most official forecasters expect. As far as the UK is concerned the world downturn has been made harder to cope with by government policy and our own actions during the past five or six years: we have too large a budget deficit and too large a debt overhang. But we are by no means uniquely disadvantaged. The developed world faces a slog rather than a disaster.

So what is to be done? The most obvious thing is not to make matters worse by nutty policies. You have to hold your head in despair as the US presidential candidates call for cuts in fuel tax. The rush to boost bio-fuel use in Europe should clearly be put on hold until more suitable crops are developed. Freeing up world trade in agricultural produce would help hugely because it would allow market signals to reach producers. Pay farmers more for their produce and they will figure out ways of increasing supply. Conserving all forms of energy helps directly and indirectly for obvious reasons.

But we have to be honest with ourselves. This is not a short-term problem. Feeding and supplying energy to a still-growing world population will be a struggle for a generation or more. We are catching a glimpse of things to come.

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