Interest rates and the weather

Strange weather patterns around the world over the last few months and the corresponding fluctuations in agricultural production have economists and market commentators hastily revising their forecasts for interest rate hikes, both locally and internationally.

In the absence of any increase in real consumer demand, however, interest rate hikes could seriously undermine the prospects for economic growth and should therefore not be purely a function of adverse weather conditions, despite the obvious impact that these conditions will have on food prices.

This is the view of Madalet Sessions, economist at BoE Private Clients, who argues that the founders of the US Federal Reserve saw the proper role of monetary policy makers as reducing interest rate seasonality and the ‘tendency for financial panics’.

“Heavy rainfall and the associated flooding in Australia, Brazil and South Africa could result in food shortages in soft commodities globally. This in turn would be the cause of higher food prices. If monetary policy authorities don’t ignore these temporary and weather dependent price effects, the lessons of the past will be well and truly forgotten,” she says.

Sessions says that prior to 1913 the most distinctive feature of the US financial and banking structure was the absence of a central bank. There was therefore no way to provide liquidity/funds in times of high demand – notably in the spring crop-planting season and the fall crop-moving season – without affecting the fixed quantity of reserves within the banking system. Shifts in demand for currency meant that interest rates rose sharply and reserve/deposit ratios fell as currency was withdrawn from the banking system.

“The likelihood that a large loan default would cause a panic increased in the seasons with high loan and currency demand. And research by the US National Bureau for Economic Research shows that prior to World War I fluctuations in the cotton harvest resulting from the weather, crop disease and other factors were responsible for most major business cycles, including the major depressions of the period.

“The US Federal Reserve came into being precisely because of the impact that agriculture had on the banking and financial system, and the need to decouple the performance of the economy from the weather, given its impact on agriculture,” says Sessions.

She urges local policy makers to ignore higher food prices (if they come to pass) in determining local levels of interest rates, arguing that the economy will adjust naturally to higher food prices but that the adjustment will be less painful if interest rates do not rise.

“Rather than raise rates because of temporarily higher food inflation – an event that will certainly cause social stress and potentially unrest, as we saw in 2007/08 – we urge the SARB to explain that these price effects are temporary and that once prices have peaked inflation rates will moderate.

“If monetary policy authorities don’t ignore temporary weather-dependent price effects, interest rates will once again be dictated by the weather and a 100 year old lesson will have been forgotten,” she concludes.