El Niño – the inflation surprise for the end of the year?

ECB’s recent economic bulletin was a reminder of how weather fluctuations can affect everything, including inflation.

I wrote in August about how climate change is a global supply side shock in the economy, the effects of which are diverse but asymmetric (full overview of the topic here). Food was one of the key factors, e.g., as an inflationary factor, and its price continued to rise sharply in the euro area based on September figures (+8.8% year-on-year).

Now,  a surprising connection to extreme weather phenomena was even included in the ECB’s Economic Bulletin. One section of the report discussed El Niño, a phenomenon where surface waters are warming up in parts of the Pacific Ocean by at least half a degree Celsius above the long-term average. According to most recent forecasts, the probability of the phenomenon occurring this year is very high, 99%, and with a 66% probability it will be strong.

Source: ECB

In the economy, this phenomenon is particularly evident in food production: in some cases it causes heatwaves resulting in downpour and in others drought. It is very difficult to forecast regional impacts but the historical analysis presented in the Economic Bulletin shows that the phenomenon has a widespread effect on increasing food prices. The report states that the temperature fluctuation caused by El Niño “accounts for almost 20% of global commodity price inflation movements since 1963 and that a normal El Niño event tends to raise real commodity price inflation by around 3% for 6-12 months after its emergence, with the strongest contribution coming from food commodities”. If El Niño is strong, global food commodity prices could rise by as much as 9%.

Source: ECB

The price increase would be highest 16 months after the onset. Based on these figures the phenomenon cannot be ignored by a simple shrug even at central banks, which is probably why it is included in the bulletin. For example, in the Bloomberg consensus estimate, the contribution of food prices to inflation is expected to dissipate completely in the coming months. If a stronger El Niño materializes, the weather may hold a inflationary surprise and the "higher for longer" interest rate mantra will get new backers. Therefore, an informed investor should also dig out their internal meteorologist and follow El Niño news.