On Coffee and Climate Change

Whether one accepts or rejects the hypothesis of anthropogenic climate change, evidences does suggest that our planet is going through yet another warming cycle.

Climatologists warn of dire consequences; global food shortages, flooding and other apocalyptic events. Such is the case of a LiveScience article, reposted on Yahoo News, that predicts that I may now be directly affected. It turns out that the coffee crop in Costa Rica is suffering from the higher temperatures.

Coffee is my life blood and I would have to take the climatologists seriously if I hadn’t been trained to observe and interpret human behavior. Economists, you see, study what people actually do, not what they should do, or what we would like them to do.

For example, climatologists warn that the polar ice caps will melt and result in increased ocean levels. One estimate I found suggests that the rise could be as much as 2 meters (6.5 ft) by the year 2100 (National Geographic). That’s about 91 mm per year (0.9 in).

Spanish Banks, Vancouver BC

Spanish Banks, a beautiful beach near the University of British Columbia, regularly has tide changes of 3.6 m (12 ft.) in a 7 hour period. That means that the water can move out by 400 meters (1/4 mile) at low tide. In the summer, families can be seen playing near the water’s edge at low tide. Children build sand castles in the wet sand.

When the tide comes in, the water level rises by a half meter (20 inches) every hour. Surprisingly, no one ever drowns. Even the children eventually realize that their fortresses are doomed and move to higher ground. Observation of human behavior suggests that, as the oceans rise, some people will build dykes to protect the property, and eventually, all will move to higher ground. This is not going to be a costless exercise, but it will happen.

The same basic human behavior will determine the price of my coffee. It may be that Peter Lehrer, author of the LiveScience article, loses his coffee plantation as temperatures rise but economics suggests that coffee prices won’t rise. As the article states, land that is higher up on the mountain and currently too cold for coffee, may become farmable. Enterprising coffee growers, reacting to price changes will plant coffee at higher altitudes. As the planet warms, it will be possible to grow coffee further from the equator, and the market mechanism suggests that people will plant there as well.

Mr. Lehrer will be incurring costs from global warming disproportionately when compared to others on the planet, but that is a topic for another blog.

Climate change will cause changes in where and how we live. The transition is going to be expensive and is going to happen when is it no longer prudent to maintain the status quo. I, for one, am going to buy some ocean front property … in Houston.

 

Why We Can’t Predict Interest Rates

An article in the Financial Post has impugned me honour and the honour of other fine economists (thanks Capt. Barbossa for the verbiage).The basis of the negative press has to do with the inability to accurately predict future interest rates. I thought, therefore, that I would take this opportunity to defend my colleagues and explain why forecasting some economic variables is so difficult. In particular, I want to look at interest rates.

First, let’s be clear that there are several different interest rates. The money market rate is the rate charged on overnight loans between financial institutions. This is the rate that the Bank of Canada uses as its policy instrument. As of Jan 2, 2014, this rate was 1%. The Bank uses this interest rate to influence economic activity and the inflation rate.

The bank rate is the interest rate the central bank charges for overnight loans to major financial institutions. The bank rate is always 25 basis points above the target overnight rate. (1 basis point = 1/100^th of 1%) When the target rate is 1%, the bank rate is 1.25%.

The prime rate is the interest rate that banks charge their best customers for short term loans. Since our banks can borrow as much money as they want from the Bank of Canada, the prime rate is closely linked to the bank rate.

The long term bond rate is the rate received for lending to government and corporations. Bond rates differ due to credit worthiness and by the length of the loan (maturity). Generally, the longer the maturity, the higher the interest rate will be. It is this interest rate that influences private business investment and the residential mortgage market.

Long term interest rates are determined by the demand and supply of loanable funds, or equivalently, the demand and supply of bonds. Central banks don’t have direct control on these rates but they can influence through open market sales and purchases of bonds with different maturities. This is what the US Fed is doing with its quantitative easing program.

To accurately predict short term interest rates we look to the Bank of Canada’s objectives and their policy tools. The Bank’s objective is to keep the inflation rate, as measured by the change in the core CPI, at 2% per year. They have an ‘operational guide’ of 2% plus or minus 1%. That is, they want to keep the inflation rate between 1% and 3% per year.

When economic activity; consumer spending, construction, exports etc. decreases, unemployment tends to rise and the inflation rate tends to fall. In response to this, the Bank lowers the target rate to encourage investment spending. When the economy expands too rapidly, the inflation rate rises, and the Bank raises the target rate to down the rate of expansion.

When will inflation rates rise? Not an easy question to answer. In the last several years the potential output of the economy has been growing faster than actual spending. Inflation increases when the economy gets close to capacity. A core inflation rate of 1.1% indicates that the Canadian economy is not operating at close to capacity. The US Bureau of Labor Statistics reports US inflation at 1.7% indicating that our biggest trading partner is also operating below capacity. Inflation.eu reports inflation rates of 2.09% in Great Britain, 1.34% in Germany, 0.68% in France, 0.23% in Spain and 0.66% in Italy. With little inflationary pressure in any of our other major trading partners, interest rates are not likely to increase there either.

So, when will interest rates rise? Not anytime soon!