Recent increases in basic food prices are severely impacting vulnerable populations worldwide. Proposed causes such as shortages of grain due to adverse weather, increasing meat consumption in China and India, conversion of corn to ethanol in the US, and investor speculation on commodity markets lead to widely differing implications for policy. A lack of clarity about which factors are responsible reinforces policy inaction. Here, for the first time, we construct a dynamic model that quantitatively agrees with food prices. The results show that the dominant causes of price increases are investor speculation and ethanol conversion. Models that just treat supply and demand are not consistent with the actual price dynamics. The two sharp peaks in 2007/2008 and 2010/2011 are specifically due to investor speculation, while an underlying upward trend is due to increasing demand from ethanol conversion. The model includes investor trend following as well as shifting between commodities, equities and bonds to take advantage of increased expected returns. Claims that speculators cannot influence grain prices are shown to be invalid by direct analysis of price setting practices of granaries. Both causes of price increase, speculative investment and ethanol conversion, are promoted by recent regulatory changes, deregulation of the commodity markets, and policies promoting the conversion of corn to ethanol. Rapid action is needed to reduce the impacts of the price increases on global hunger.

Eoin Treacy's view Fullermoney has long held the view that commodities were never meant to serve as long-term investments or assets. (Also see Comment of the Day on May 11th 2011).

Intuitively, if passive investors, buy and hold a comparatively large position in a relatively small market, they cannot but have an impact on price. In simple supply and demand terms, more buyers chasing comparatively limited supply drives prices higher. A Pakistani cotton trader at The Chart Seminar in Singapore last year recounted how the increased volatility had forced the exchange to widen its limits on outstanding contracts. This put severe pressure on those depending on the futures market for normal hedging activity. This is not an isolated case and has been experienced intermittently across commodity markets over the last decade.

The mandate for ethanol as an oxygenate in gasoline is a specifically US issue. In the EU, set-aside and demand for biodiesel are comparable situations. The supply and demand argument is equally true in either. If a mandate for greater consumption is created without a correspondingly large supply response, prices can only go up.

In the USA, the removal of the subsidy and trade tariffs on Brazilian ethanol may help to alter the dynamics of the corn market over the medium term. Much will depend on the relative performance of corn versus sugar and the strength of the Brazilian Real versus the US Dollar.