Continental Drift -- Toward Inflation

The heat wave and recovery expectations are driving up prices for food and metals

August was a tough month for Peter Jones, a veteran wheat buyer and director at Rank Hovis Ltd., Britain's leading flour mill. The summer's heat wave and drought badly damaged this year's European wheat crop. As a disappointing harvest crimped supply, traders pushed wheat futures sky-high. Prices are expected to remain elevated for the foreseeable future, so Rank Hovis bit the bullet: It raised prices on its main grades of flour by $58 per metric ton, an increase of 15% to 20%, depending on the grade, marking the first hike in a decade. "As millers, we were left with no choice but to pass that price increase onto our bakers," says Jones. "It's a major event."

Despite concerns about deflation earlier this year and the euro's rally against the dollar, inflationary pressure is slowly building across the Continent. Prices of industrial metals such as aluminum, lead, and zinc are rising on signs that a global economic recovery is about to take hold. The strength of the euro is also stimulating demand by encouraging major buyers to stock up on dollar-priced metals, says Ingrid Sternby, metals analyst at Barclays Capital in London. At the same time, with the autumn harvest outlook bleak, traders and industrial users are scrambling to lock in grain prices -- before they head still higher -- by bidding up futures contracts. As a result, the cost of grains and raw materials -- from corn to copper -- has quietly increased in recent months. And for the first time in years, farm and mining interests around the globe expect to profit from the convergence of constricted supplies and higher demand.

The problem is particularly acute in Europe, where the drought and heat wave combined to boost a range of agricultural prices. High shipping costs and restrictions on grain imports preclude rushing in shipments from overseas. The International Grains Council in London says world wheat production will be 556 million metric tons this year, a drop of 10 million tons from 2002 and an eight-year low. Germany's wheat production will be 7% below last year's, while France's output will decline 20%, reports the U.S. Agriculture Dept.'s Foreign Agricultural Service. Those two countries alone account for more than half of total European production. The shortfall has sent wheat prices soaring 27% in the past two months on the futures market of the London International Financial Futures & Options Exchange (LIFFE.)

The bidding up of wheat futures has hit harder in Europe than in the U.S., where prices are up about 10% since July after a similarly challenging growing season. And there are few signs of improvement on the horizon: Farmers in France are dipping into their winter fodder stocks to feed cattle. That's sure to drive grain and beef prices even higher in the months ahead. "There's a new whiff of inflation in Europe," says Carl B. Weinberg, chief economist at High Frequency Economics Ltd. in Valhalla, N.Y. "This could be very significant in terms of its size and its magnitude."

True, the runup in inflation could be short-lived if demand plateaus or if the euro continues to strengthen against the dollar, driving down import prices. But that's unlikely to happen overnight, so central bankers are on the watch for signs of broader price creep. Incoming European Central Bank chief Jean-Claude Trichet, a well-known inflation hawk, will have to decide whether worries about soaring commodity prices trump concerns about weak consumer demand in Germany and France. If inflation is a concern, ECB watchers say, Trichet isn't likely to lower rates, even though many investors and business execs are hoping for another cut. "The ECB can keep interest rates steady through next year," says Neville Hill, European economist at Credit Suisse First Boston in London.

Most economists predict pricing pressure will persist well into 2004, with inflation rising to 2.5% from a current 2.1%. But a small group, including High Frequency's Weinberg, expect high food prices to push euro zone inflation above 3.5% -- the highest in over two years. He notes that in 2000, higher prices for "fundamental foodstuffs" alone, such as grains, added a full percentage point to euro zone inflation. Even skeptics predict at least a short-term price spike. "If you look at the very near term -- the next three to six months -- there are some significant inflationary pressures ahead," says CSFB's Hill.

Consumers are already feeling the pinch in grocery store aisles from Athens to Oslo. The price of a loaf of bread in Britain, for instance, is expected to rise 15% in September, to about 95 cents, according to economists at CSFB. Prices for fruits and vegetables are rising, too, boosting food inflation in Europe to 2.6% in August. Fortunately, for now consumers seem to be swallowing the price hikes instead of cutting back on spending. "We have seen inflation in produce in the last month or two," says Andrew T. Higginson, finance director at Tesco PLC, the British grocer. "The costs are higher, but we're able to pass that on to consumers."

Of course, shoppers aren't the only ones watching those prices climb. The central bankers of Europe are keeping an eye on the shopping bills, and they may not like what they see.

By Laura Cohn in London

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