Worldwide droughts add to ‘fossilflation’ in price stability crisis

August 22, 2022|Written by Graham Caswell|Banco Central do Brasil, European Central Bank, Federal Reserve

Multiple droughts associated with accelerating climate change are adding to fossil fuel inflation and supply chain bottlenecks to intensify the growing cost of living crisis. However, the response from central banks has been slow and seen by some as failing to tackle the threat of price instability.

Numerous indicators show that reduced rainfall and extreme heat in large parts of Europe, Africa, the Americas and Asia have impacted food and energy production. As well as raising prices, this has compounded the price instability sparked by Russia’s invasion of Ukraine and the economic disruption of the Covid-19 pandemic.

The European Commission’s Joint Research Centre reports that nearly half of EU territory is currently experiencing drought conditions, driving down agricultural production. Italian production of olive oil, rice and tomatoes has been dramatically affected, with importers expecting price rises of up to 50%. France’s corn harvest is likely to be over 18% lower than last year, while farmers’ unions warn that a shortage of cattle fodder could lead to significant milk shortages in the autumn and winter.

Substantial reductions in yields of cereals and other crops are also expected in many other countries, including France, Romania, Spain, Portugal, Germany, Poland, Hungary, Slovenia and Croatia, putting further pressure on food prices.

The UK is also experiencing drought with prices of meat, dairy and vegetables expected to rise dramatically. The Office for National Statistics said the consumer prices index rose by 10.1% in the year to July, driven largely by soaring food and energy costs.

This comes on top of food prices that have already risen by 11% in the EU and nearly 10% in the UK compared to last year.

The European drought, which could be the worst in 500 years, is part of a global trend linked to climate change. Drought frequency and duration has increased by nearly a third globally since 2000, according to the UN.

A Kenyan man holds up a maize cob while several other men harvest maize in the background
Drought in East Africa threatens millions of people with severe hunger, according to the FAO © Curt Carnemark / World Bank

Over half of the US experienced drought in July, including key agricultural regions, while in China intense heat is expected to significantly reduce this year’s rice harvest. In Brazil, agricultural GDP dropped by 8% in the first quarter of 2022 due to a lack of rainfall, increasing the price of coffee, soya, corn, milk and other agricultural commodities. As a result, the value of unpaid farm loans rose by 103% in the year to February 2022, according to Brazil’s central bank.

Drought is also contributing to rising energy prices, exacerbating the fossil fuel inflation caused by the war in Ukraine. Lack of rainfall has significantly reduced hydroelectric generation capacity in Europe, the United States, Brazil and other countries with further disruption expected. Low water levels on the Rhine have threatened deliveries to coal-fired power plants, while warmed and lower rivers may impact nuclear energy in France by reducing the ability to cool reactors.

However, Africa is by far the worst affected according to a recent UN report. The Food and Agricultre Organization has warned that over 18mn people are facing severe hunger as Ethiopia, Somalia and parts of Kenya experience their worst drought in over 40 years. Hunger is also widespread in Madagascar as a result of drought, with much of Africa facing acute food insecurity due to rising prices and extreme weather.

In Sierra Leone, at least 21 protesters were killed last week during anti-government protests over the rising cost of food and other basic necessities.

However, while price stability is the core mandate of most central banks, they have been slow to address these drivers of inflation. Instead, the European Central Bank (ECB), the Federal Reserve and others have raised interest rates, despite warnings from critics that this will have no effect on the external factors causing price rises.

Perversely, efforts to mitigate fossil fuel dependence and the climate change behind increasing food prices could be harmed by increased rates, according to a recent article published by the London School of Economics.

“ECB interest rate hikes cannot increase the supply of gas from Russia, nor can they open up alternative energy sources or solve supply chain problems for chips and semiconductors,” the authors say, pointing to the high capital expenditures required to shift the world away from fossil fuels and their greenhouse gas emissions. “The higher the cost of capital, the less attractive an offshore wind farm is,” they add. “Higher interest rates are therefore a problem for the green transformation.”

With forecasts predicting that warmer-than-average temperatures are likely to persist over much of Europe until October, and Russia threatening to cut fossil fuel exports during the coming winter, pressure on food and energy prices is likely to continue in what could become a perfect storm of price, economic and financial instability.

A geopolitical fossil fuel squeeze and a climatic crisis have come together to create a growing problem for central banks attempting to fulfill their primary mandates of price stability. But it is becoming increasingly clear that this stability, if it is to last, can only come from a rapid transition to sustainable energy sources.

This page was last updated August 22, 2022

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