Does El Niño contribute to a ‘perfect storm’ of inflation?

The current El Niño has already reached record levels, while its peak is still expected to lie ahead. That means we are entering partly uncharted territory, says Peter Verbaken, Head of Liquid Commodities at APG. We spoke with him about the potential economic consequences of El Niño, particularly its impact on already elevated inflation.

What are we already seeing from El Niño?
"For one thing, agricultural commodity prices have already risen by more than 20 percent this year. This so-called super El Niño is expected to persist until early 2027, which could amplify its impact and push prices even higher over the next six to twelve months.

Most crops are harvested twice a year: around this time in the Northern Hemisphere and during our spring in the Southern Hemisphere. It is the Southern Hemisphere harvests that are expected to be affected most severely. That means the supply of agricultural products could be significantly lower than expected by the first quarter of next year. Inventories can absorb only part of that shortfall. For the rest, markets will have to wait for the next Northern Hemisphere harvest. As a result, price increases could remain visible well into next year.

Food prices account for roughly 14 percent of the consumer basket used to calculate inflation. That share is large enough to have a meaningful impact on inflation. And that impact comes on top of the price pressures that emerged earlier this year following the energy shock triggered by the conflict involving Iran.

If an inflation shock caused by food and energy prices remains temporary and conditions eventually normalize, central banks often do not need to intervene much. The effect gradually fades away on its own. It becomes more problematic when higher prices become embedded in expectations. That can lead to rising inflation expectations, higher wage demands, and further price increases: the well-known wage-price spiral. At that point, the impact of El Niño could extend far beyond higher agricultural prices alone.

Another factor is that the consequences of El Niño can overlap with those of climate change, reinforcing one another. Think of extreme drought in certain regions, increasing the risk of wildfires. Or extreme rainfall, raising the likelihood of flooding. Organizations such as the World Food Programme have therefore sounded the alarm about this scenario, warning that another fifty million people could face hunger as a result."

To what extent can adaptation and mitigation measures soften the effects of El Niño?
"Let me put it this way: when a weather event of this magnitude occurs, the options for reducing its impact are limited. In some regions, irrigation can help to a certain degree. In others, farmers are almost entirely dependent on weather conditions. If, for example, the Indian monsoon fails to arrive or is much weaker than usual, that has major consequences for the harvests of the many small farms that depend on it.

Weather conditions may temporarily benefit certain crops in specific regions, but those gains are usually outweighed by the negative effects in areas that are hit hardest. For most agricultural commodities, the overall picture therefore remains negative, although some products are more vulnerable than others. Sugar ranks high on that list, as do corn and soybeans. Wheat is also affected by the war in Ukraine. Russian attacks on Ukrainian infrastructure have once again reduced exports from the region.

In addition, the situation in the Middle East could have implications for future agricultural production. A significant share of the world's fertilizers comes from the Middle East. Supplies have been constrained by tensions in the region, and prices remain high. As a result, many farmers have used less fertilizer, leading to lower expected yields per acre.

Demand-side dynamics also play a role. High energy prices have made fuels historically expensive. At the same time, those higher energy prices are boosting demand for certain agricultural commodities. Many agricultural products are processed into fuels, including ethanol blended into gasoline and biodiesel blended into diesel. As a result, demand for ethanol, biodiesel, and the feedstocks used to produce them, such as corn, soybeans, and sugar, has increased.

The energy shock already has significant consequences on its own. But through fertilizer markets and rising demand for biofuels, it further amplifies the effects of El Niño on agricultural production."

Can we speak of a kind of perfect storm of factors coming together this year?
"If energy prices remain high or move even higher, while food prices continue to rise sharply, you end up with a very complicated mix of factors that is also difficult for central banks to address. They can raise interest rates to curb demand and, hopefully, dampen some of the price increases. But they cannot solve a supply-side problem in energy and food markets. And that means the risk of structurally higher inflation remains."

Is there any bright spot in this story?
"The consequences of an El Niño of this magnitude are difficult to predict. We are, to some extent, entering uncharted territory. That also means outcomes could be less severe than expected. A potential bright spot for Europe is that previous El Niño years have often been associated with milder winters. Given the current state of the European gas market and relatively low inventories, a mild winter would certainly be welcome.

That said, there is an important caveat. While El Niño winters in Europe tend to be milder on average, they are also associated with a higher probability of a so-called polar vortex. In other words, extremely cold Arctic air can travel farther south than usual. As a result, even though average winter temperatures may be higher, the risk of a period of extreme cold is also somewhat greater than normal."