On droughts and inflation

Hey, have you noticed? It's been really hot this summer. Like, absurdly hot. And dry. And this could be a really, really big problem for our economy.

The nation is experiencing its worst drought in over half a century. Grain crops, particularly corn, are being devastated as only 31% of the domestic corn crop in is good shape versus 40% just one week ago. The same is true for soybeans as only 34% is in good shape versus 40% last week.

As a result both commodities have hit record highs on the world futures market. For the first time in history corn exceeded $8.00 per bushel to $8.05 (one year ago--$5.50) and soybeans are at a high of $17.12 per bushel ($10.90 a year ago). It is projected by some commodities experts that these price may go up yet another 20-30%. The inflationary impact of these vital grains will be felt very soon in the nation's grocery stores as virtually all meat and many processed foods are dependent on these commodities. This on top of an economy that is already languishing in recession levels.

Right. Food inflation is bad, especially for those of us on already-strained budgets when unemployment remains stubbornly high. Things have gotten so bad that ranchers can no longer afford to keep/feed their cattle herds, so they're selling them off at auction at bargain-basement prices. So the corn and grain shortage in turn causes a meat shortage, meaning that the spillover effects on food prices are likely to be far-reaching. (Check below for a graphical representation of this year's drought versus previous years).

Chart from NY Times via Barry Ritholtz; CLICK to enlarge

But in my opinion, the more concerning issue here is what this might mean in terms of future Fed policy, which we haven't taken much time to discuss here in recent months. Now seems like a good time to change that.

Over the last few years, our economy has become increasingly dependent upon loose Fed policy to keep itself going (and to allow the federal government to finance its ever-growing debt). Recently, the economy has begun to show significant signs of slowing growth, and as a result people everywhere are calling for a third round of "quantitative easing"—a policy that I absolutely hate—to help out the economy.

That's great and all, but can the Fed really afford to engage in inflationary monetary policy at a time when American consumers are already getting squeezed at the supermarket? Yes, the Fed claims to largely ignore food and energy prices when considering their policies (because those prices are "noisy"), but there's no way they can ignore the impact that the ongoing drought is likely to have on national price levels. This drought will likely give the Fed even less room in which to operate, making a declaration of QE3 that much more difficult to sell to an increasingly-skeptical American public.

If nothing else, this drought should serve as a very loud reminder to everyone in the world that the Fed and other central banks are not the only determinant of price levels in the global economy. Maybe Ben Bernanke's consistent attempts to play God angered Mother Nature, and she decided to show him who's boss after all—like Icarus before him, the Chairman flew a little too close to the sun, and all of us got burned.

For all of us, if we're looking to the Fed (or the federal government) to be our savior, we should know that there are limits to the bank's power—this drought threatens to make those limits pathetically obvious to all of us, and in the long run that may be a very good thing. But it may be a very bad thing over the next several months, for those of us who like to eat.

[American Thinker]