The World Meteorological Organisation announced on July 4 that there is a 90% probability of an El Niño event in the second half of this year that will warm the surface of oceans and add to the climate change impact. That could have a major negative impact on things like food production and energy demand.

El Niño leads to above average sea surface temperatures in the central and eastern tropical Pacific Ocean and occurs every few years. It typically leads to drier weather across West Africa, Southeast Asia and northern South America, and wetter weather in southern South America.

“The likelihood of an El Niño event in the second half of this year adds to upside risks to global inflation and downside risks to activity. For the advanced economies, higher prices of agricultural commodities could slow the decline in food inflation. But the risks are bigger in EMs where food has a higher weight in the CPI and where production could also be damaged,” Jennifer McKeown, chief economist at Capital Economics, and Gareth Leather, senior Asian economist at Capital Economics, said in a note on July 12.

The potential impact of El Niño on food and energy prices which are already inflated has worried analysts. While the relationship between El Niño events and agricultural commodity prices has been inconsistent, there are potential upside risks to prices, including sugar, cocoa, coffee, and rice, says Capital Economics. And the Emerging Markets are particularly vulnerable.

Developed markets facing mild impact..

Historical data suggests that the threat to headline CPI inflation in advanced economies is limited. Food comprises an average of 12% of their CPI baskets, with sugar, sweets, coffee and rice components making up around 2% of the basket. During the strong El Niño event in 1997/1998, food inflation rose by a percentage point, adding 0.12 percentage points to the average headline CPI rate in the OECD.

Nevertheless, there is no clear causal relationship, says Capital Economics, and there have been instances where OECD food inflation actually decreased during other El Niño periods. This inconsistency can be attributed to the variable impact on commodity prices, as well as the fact that other factors play a more significant role in determining food prices in advanced economies. Factors such as processing, packaging and retailing costs have a greater influence. For example, there is little correlation between annual changes in the global sugar commodity price and CPI inflation in sweet goods like biscuits, sweets and jam in major developed markets.

El Niño may also exert upward pressure on gas and coal prices due to reduced hydropower generation in Asia or increased demand for air conditioning. This could lead to higher energy inflation and contribute to any upward pressure on food prices. Notably, energy prices were the primary driver of higher food inflation in advanced economies last year, while the decline in agricultural commodity prices during that period had minimal impact.

“In all, we estimate that the combined contributions of food and energy could be around half a percentage point larger in a “strong El Niño” scenario over the next year than under our baseline scenario. That would leave average advanced economy inflation at 3% rather than 2.5%. But we would stress that the effect is highly uncertain and global demand and labour market conditions will be the more important determinants of food and energy inflation as well as price pressures generally in the advanced economies,” Capital Economics said.

.. but Emerging Markets at greater risk

The impact of El Niño on emerging markets could be more severe for several reasons. First of all, food constitutes a significant portion of the consumer price basket in these markets. Since processed foods are less commonly consumed and labour costs tend to be lower, the prices consumers pay are more closely linked to raw commodity prices compared to advanced economies. Historical data indicates that El Niño conditions often coincide with higher food price inflation in emerging markets. The risks are particularly pronounced in Africa and South Asia, where food comprises a significant share of CPI baskets.

Secondly, a decrease in agricultural production will directly affect the GDP of certain emerging markets. Cocoa (predominantly from Côte d'Ivoire and Ghana), sugar (especially from India and Thailand), coffee (Vietnam and Indonesia) and rice (Philippines and Thailand) are among the key commodities at risk.

Agriculture plays a larger role in the GDP and employment of Africa and South Asia compared to other regions, making these areas particularly vulnerable to the impact of a strong El Niño.

A significant reduction in crop volumes available for export could strain the balance of payments in some economies. Certain regions in Africa, as well as Laos, stand out as being reliant on agricultural exports while simultaneously facing substantial external vulnerabilities.

Thirdly, there could be broader economic consequences. Several countries, primarily in Africa, heavily rely on hydroelectricity for power generation. A decrease in rainfall could hinder electricity production and potentially lead to power rationing. Additionally, heavy rainfall in Chile has already disrupted the country's copper mining industry.

“In all, the prospect of an El Niño event has not led us to change our forecasts at this stage, given the uncertainties around its strength and the impact on commodity production and prices. However, it has increased upside risks to inflation and downside risks to activity which will only worsen the dilemma for central banks. The risks are greatest in EMs, where El Niño conditions threaten to prevent more central banks from cutting interest rates and could cause balance of payments strains to intensify for some,” Capital Economics concludes.