Food producers are facing rising raw material costs, particularly for dairy ingredients and wheat, making food price inflation almost inevitable. But, writes Dean Best, in the midst of a continuing price war, supermarket retailers will only pass on cost increases to customers as a last resort, making a further squeeze on supplier margins also extremely likely.

The new story is food. Those were the words of one analyst this week as he considered the impact of rising costs - and their effect on food prices - across the global economy.

The cost of raw materials, including dairy and wheat, has been a cloud on the horizon of many a food producer in recent months. What's more, with it being results season, the issue is steadily rising up the agenda in the business press.

Companies including Dean Foods, Cadbury Schweppes, Danone and, this week Nestlé, have all flagged up rising input costs as a threat to margins. Some, like Nestlé, seem better placed to handle the mounting bill. Nonetheless, there is almost complete agreement among industry players and watchers that raw material costs will continue to rise - and that food prices will increase as a result.
 
Growing demand for biofuels as an alternative, "greener" energy source has been highlighted as a key factor in the rising cost of corn, for instance, with the US, a significant producer of corn, diverting production of the crop away from food. The growing affluence of India and China has also put pressure on corn supplies with more consumers in these markets switching away from subsistence consumption to protein-based diets.

And then there is the impact of the unusual. The ongoing drought in Australia has restricted the supply of dairy products, for instance, while the recent severe weather in the UK has hit supplies in a number of sectors. So costs for food producers are going up - but to what extent will this cause the price of food to rise, or in economist-speak, cause "agflation"?

In the UK, food producers, beset by problems linked to the floods across much of the country, have pleaded with the country's retailers to increase prices. Earlier this month, the CEO of Pinguin, one of Europe's leading vegetable processors, told just-food it is a matter of "national interest" for UK retailers to help the sector ride out the recent severe floods in the country.

At the same time, however, three of the country's top four retailers have moved to slash prices across a range of products. Tesco, Asda and Morrisons have embarked on something of a price war, being only too aware that UK consumers are finding their spending power reduced after a series of interest rate rises.

With the UK's largest retailers once again seemingly competing on price after a relatively robust 2006, how much room is there for rising supplier costs to be passed on to consumers? Will the likes of Tesco stand firm on price cuts, hurting suppliers' margins? Or will they absorb the higher costs themselves?

One UK analyst, Investec's Nicola Mallard, believes the higher costs will ultimately be passed on to consumers. "Food prices will go up, that's guaranteed," she tells just-food. "These are not modest [raw material] price increases we are talking about; I'd be surprised if they're not passed on." What's more, Mallard warns, the full impact of higher food costs is yet to be felt. "The inflation from this hasn't hit yet; it will be seen in the next two and three months easily

Mallard argues that food processors, after a decade of facing low prices on supermarket shelves, will not be able to absorb the hike in raw material costs. The UK's largest retailers may be fierce rivals, she argues, but there will be scope for them to pass on prices to consumers, as public awareness of issues like rising biofuel production and the impact of the UK floods on the food industry increases. Consumers, it seems, are bracing themselves for the double whammy of interest rate rises and higher food bills. "There is now an expectation among some consumers for prices going up," she says.

That view is echoed on the other side of the Atlantic. There are signs in the US that retailers are already passing on higher food costs to consumers, who are themselves feeling the pinch as Wal-Mart boss Lee Scott warned earlier this week.

"The scanner data shows across the board price increases across many categories," says Sanford C. Bernstein analyst Alexia Howard. She tells just-food that, just as in the UK, growing publicity over issues like biofuels is creeping into the consciousness of many consumers. "Media coverage has picked up exponentially and consumers have become re-educated to expect food price inflation and sure enough, you've started to price increases come through."

Indeed, for Howard, it's the rising biofuels production that is one of the key factors in recent food price inflation. "Food companies started seeing significant commodity cost inflation in mid-2003 on stocks like coffee, meat and cheese," Howard says. "From 2003 to late 2005, these were all seen as one-off, anomalous shocks that had impacted food companies but which they had soaked up. Since about Q3 last year, grain inflation has taken over."

However, not all food producers should sit comfortably in the knowledge that their higher costs will be passed onto consumers. Particularly here in the UK, retailers have gone all out to fight an offensive on price and consumers, only too aware that their spending power is being eroded, will be keen to look for the best value for money.

Darren Shirley, a UK analyst at Shore Capital, believes some food firms are better placed to ride out this storm than others. Only some, he argues, will successfully be able to pass on their higher costs to consumers.

"You can't apply this across the board," Shirley says. "For companies like Premier Foods and Associated British Food, they have decent stables of brands so they have the potential to pass the costs on. I'm more worried about private-label, own-label producers; if you're a bog-standard ready meal producer like Northern Foods or Uniq, it won't be easy to get price increases through."

One thing is certain, however, food may be the new story but it will not make happy reading for all.