Chris Tennent-Brown, Economist, on New Zealand's diary prices and economy

Source: Dukascopy Bank SA
© Chris Tennent-Brown
Milk prices in New Zealand have fallen 35% since February, and world prices for it are down nearly 39%. Even though New Zealand's dairy prices are tipped to rebound later this year, the expectations have been tempered by falling demand in China and increased production in Europe. The opposition's opinion is that the Government has relied on milk and the Canterbury rebuilt too much to survive the global financial crisis. What are your thoughts on this matter? And what could be the consequences for the economy with even lower prices for milk? 

The strong New Zealand dairy production season, along with rising European and US supply, is putting continued downward pressure on global dairy prices. As a result, we expect Fonterra will revise down its milk price payout for the 2014/15 season to around $6.20 per kg of milk solids, from its initial estimate of $7. This decline in export prices will see the Terms of Trade fall sharply from 40-year highs over the coming year, and contribute to more moderate growth in business investment and household spending over 2015. However, dairy and forestry prices have fallen considerably this year and as a result NZ's Terms of Trade will drop from the Q1 peak. 

The NZD generally follows New Zealand's Terms of Trade, for which export commodity prices are a key driver. Over a 40-year period the NZD/USD (adjusted for inflation differentials with the US) has tracked the long-run trend in the Terms of Trade. In doing so it provides a buffer to swings in fortune in the tradable sector, and the broader economy. Whereas, residential construction grew strongly over the past year, led by earthquake rebuilding in Canterbury and house-building demand in Auckland. We expect construction growth will continue to lead the economy, but the growth rate is likely to moderate to a more sustainable level. 

Lately the Kiwi's strength has put a downward pressure on the price of imported household goods and that together with the decline in the New Zealand's export prices are raising concerns. Keeping in mind that the new tightening cycle has been announced just recently, what could that mean to the country and also its currency? 

Despite the recent decline in export prices, the NZD has remained stubbornly high, even appreciating further while dairy and forestry prices have fallen. The pull of interest rates is dominating the moderation of export commodity prices. We expect NZ's relative interest rate advantage over the rest of the world will continue to hold the NZD up into early 2015. For the RBNZ that represents a challenge: it would prefer higher interest rates to contain domestically-generated inflation pressures but a lower NZD to aid a better balance of economic growth. 

Continued strength in the NZD, assuming it occurs, will leave the RBNZ having to temper how far interest rates would otherwise go up. While we sympathize with the RBNZ's belief the NZD should be responding to the substantial decline in dairy prices, the NZD can deviate for a period from commodity price movements. That happened quite clearly over 2012 (the NZD strong, as commodity prices fell), and around 2000 (commodity prices lifted but NZD eased).

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