By Bernard Hickey
Reserve Bank Governor Alan Bollard has said in a speech that agricultural export prices are likely to remain strong for some time and the bank expected these higher terms of trade to be reflected in the exchange rate.
The Reserve Bank would focus on medium term inflation, rather than on the terms of trade, Bollard said.
Bollard's comments essentially mean he sees the currency's rise acting as an automatic stabiliser for the economy, helping the Reserve Bank deal with the inflationary effects of an historic improvement in the terms of trade. The higher currency softens the expansionary effects of higher export prices and reduces the impact of higher commodity prices in US dollar terms. It helps reduce inflationary pressures.
However, allowing a higher currency also makes it more difficult for exporters to expand rapidly and could encourage more imports, thus worsening our trade balance and making it more difficult to turn around New Zealand's structural deficit.
The comments, seen as a green light for a rise in the currency, saw the New Zealand dollar rise in late morning trade to over 78 USc. Bollard's comments came after a call from Barclays Capital's Peter Redward for Reserve Bank intervention to bring the New Zealand dollar lower. See more here in Redward's full opinion piece.
Speaking to a farming group, the Grasshoppers, in Ashburton last night, Bollard said the Bank expected the higher terms of trade to continue to be reflected in the exchange rate, as it is currently.
The exchange rate would deliver the benefits of the rising terms of trade to the community at large – through higher wealth and cheaper imports, he said.
Global commodity prices had experienced the largest boom in more than 100 years, Bollard said.
While hard commodities had seen the biggest surge, agricultural commodity markets had also seen a fundamental change. Another surge in prices has since seen food prices surpass the 2008 record level, boosted by supply disruptions, particularly in grain markets, he said.
"Analysis by the Bank indicates New Zealand’s agricultural export prices are likely to remain elevated for some time. Although in the near-term, prices could fall slightly as supply becomes less weather-disrupted, demand is underpinned by urban and wealth growth in developing countries, especially China," Bollard said.
The Bank’s analysis can be found here. Given this outlook, monetary policy will remain focused on any medium-term inflationary pressures that arise, rather than the terms of trade shift in itself," Bollard said in a news release issued after the speech, which is linked to this research paper.
If households and firms use the income boost from higher commodity prices and exchange rates to bring forward consumption and investment, or increase borrowing, then pressure on resources in New Zealand would lead to more inflationary pressure. Monetary policy would need to counteract any rise in inflation expectations," he said.
"One thing we do know is that the projection will remain uncertain. History shows it is fiendishly difficult to predict the future path of commodity prices."
'High currency has been a headwind, but export sector getting better'
Finance Minister Bill English said a high New Zealand dollar had been a headwind for the economic recovery "right from the start".
"And that’s been driven to a large extent by policy in the US, the UK and Europe," Enlglish told journalists in Parliament this morning.
"We’ve been fortunate to have at the same time, and related to the high currency, very high commodity prices, which are higher than they’ve ever been. So we can see the export sector is making progress, it’s going to become profitable as it gets its debt levels right," English said.
"Of course that could happen faster if the currency was lower,” he said.
“It’s not just [high] commodity prices [helping] of course. We’ve got a very competitive exchange rate with Australia at the moment, which is a big help to manufacturers and people selling services into Australia," English said.
"So the export picture is pretty strong, despite the fact that we have a high currency against the US and the Euro. We do have a very competitive currency against Australia, so New Zealand companies are benefiting from that.
“It’s up to the Reserve Bank to decide how they do their business. All I’m saying is that despite the fact of the high currency and the headwind that means for our recovery, exporters are still doing pretty well for two reasons; Commodity prices are high, and the currency against Australia is very competitive,” he said.
'Structural shift in terms of trade'
Here is the executive summary from the RBNZ research paper upon which Bollard based his speech:
We conclude demand is underpinning commodity prices, creating a structural shift in the terms of trade of commodity exporters like New Zealand. Against this backdrop, idiosyncratic events such as weather-related crop failures and changes to government policies have pushed prices to historical highs. Supply responses will be relatively slow, implying prices are likely to stay high over the short to medium term, if a little lower than current levels.
New Zealand’s agricultural export prices are likely to remain at elevated levels for some time. Demand is underpinned by urbanisation and wealth growth in developing countries, especially China. However, there is potential for near term price falls as supply becomes less weather disrupted.
The appropriate monetary policy response will focus on the inflationary pressure that arises, not the terms of trade shift in itself. Higher terms of trade will contribute to appreciation of the exchange rate, facilitating the necessary adjustment in the real exchange rate via the nominal exchange rate rather than via rising inflation.
Medium term inflation remains the Bank’s focus. The Bank needs to be cautious that a terms of trade increase does not lead to increases in inflation expectations. For example, households and firms might use the income boost from higher commodity prices and exchange rates to bring forward consumption and investment, or increase borrowing. Consequent pressure on resources within New Zealand would lead to more inflationary pressure and monetary policy would counteract any rise in inflation expectations.
Here are other selected sections from the study.
Growth in food demand is fastest in the early stages of a country’s development. As countries become wealthier, consumer preferences switch from merely more food, to higher nutrient food. So in the initial stages of development a country may consume higher quantities of rice, but as wealth continues to grow, other grains, such as wheat, become more popular, and then dairy and meat become larger parts of the national diet. Eventually food demand becomes dictated more by population growth than income growth.
Worldwide, a surge in demand for meat and dairy can have large multiplier effects on the demand for grain and water, given that it takes, on average, 3kg of grain and as much as 16,000 litres of water to produce 1kg of meat (this assumes most meat will be produced in feedlots). Hence, when current grain prices are elevated the cost of producing meat and dairy rises. This represents a windfall gain to producers like New Zealand where grain inputs are relatively low.
The demand curve for a number of agricultural markets has seen a structural shift – higher and more inelastic – with emerging market demand and policy changes eroding world inventory levels at a rapid rate. The Dutch agricultural financing cooperative, Rabobank, formed this view after observing downward sloping forward curves in almost all agricultural markets at some point during 2010. Rabobank said this reflected the markets’ needs for delivery of increased near-term supplies and the encouragement of increased production next season.
Moreover, the Australian forecasting agency ABARES agrees. Its view encapsulates strong economic growth, and hence commodity demand, to continue in developing economies, particularly in China and India. Its projection is for export earnings for Australian minerals and energy commodities to rise in real terms over the next five years.
Policy response
For a central bank, the question of whether or not to respond to terms of trade shifts with monetary policy depends on whether it causes changes in the behavior of households and firms, or inflation expectations. Nevertheless, monetary policy should remain focused on the medium term objective of price stability.
We see current high commodity prices explained by two key factors. Underlying demand represents a structural shift, raising New Zealand’s terms of trade to a permanently higher level. Similarly, supply constraints caused by the rise of biofuels and the reduction in production subsidies add to this permanent effect. At the same time, weather events have pushed prices above what can be explained by this structural shift, though are expected to be short-lived. In themselves, neither of these elicit a monetary policy response other than maintaining a flexible exchange rate regime, allowing the economy to adjust appropriately to the former, while looking through the inflationary effects of the latter.
The potential for prices rises to be persistent, but not permanent, exists but this is not our central view. For example, governments may decide the costs of subsidizing biofuels are too high and withdraw this support, flooding grain markets. At present we view this as very unlikely.
In maintaining a focus on medium term inflation policy makers will need to be cautious that terms of trade increases do not lead to increases in inflation expectations. Should households and firms decide that the income boost from higher commodity prices and exchange rates enables them to bring forward consumption and investment, or increase borrowing, it is possible an internal demand shock will arise. Consequent pressure on resources within New Zealand would lead to more inflationary pressure. Monetary policy would then act to contain any rise in inflation expectations.
Other central bankers with similar issues see exchange rate flexibility as the best mechanism for coping with a structural adjustment in the terms of trade. The Reserve Bank of Australia sees the high terms of trade that commodity prices have delivered as a long-run phenomenon, pointing to the expected longevity of China and India’s growth. They view the events as a structural change in the economy, and that the structural change is overall healthy for the economy. Further they see the high exchange rate as delivering the benefits of the rising terms of trade to the community at large – through higher wealth and cheaper imports.
“There is going to be a non-trivial degree of structural change in the economy as a result of the large change in relative prices. This is already occurring, but if relative prices stay anywhere near their current configuration surely there will be a good deal more such change in the future. Because we can't confidently forecast where relative prices will settle, we cannot know how much such change is ‘optimal’. Therefore we can't be sure that some of it will not need to be reversed at some point. But the optimal amount of change is unlikely to be none at all. So we should not look to prevent change; we should look to make it cost as little as possible. In general, that means preserving flexibility and supporting adaptation. “ Glenn Stevens, Governor, Reserve Bank of Australia, February 2011
Recent Bank of Canada statements support the view that underlying demand has delivered a structural change in commodity prices. Further, the Bank of Canada warns
“From a policy perspective, it matters whether prices are being primarily driven by demand, supply or speculation. In general, supply shocks and speculative overshoots tend to be short lived and can be looked through. Demand shocks are different.
Policy-makers determined to take corrective action should proceed with caution. Without a clear diagnosis it is difficult to talk about remedies and policy fixes with any confidence.
Canada has learned through long experience that the role of the exchange rate is crucial. For commodity exporters, improvements in the terms of trade tend to put upward pressure on the exchange rate. When such movements in the nominal exchange rate are limited, wages and a range of other prices respond. This is a more disruptive form of adjustment that can have profound implications for employment, financial stability and competitiveness—the very objectives exchange rate management seeks to protect.” Mark Carney, Governor, Bank of Canada, March 2011
Overall, the consensus seems to be that monetary policy should maintain its focus on medium term targets. Current demand conditions suggest that some upward movement is structural and monetary policy can do little. However, there are also factors at play pushing prices higher than the structural change would suggest. Nevertheless, these are likely to be rather short-lived and outside the medium-term objective of monetary policy.
Here is JP Morgan's Helen Kevans' reaction
Our long-held view is that the boost to national income from the higher terms of trade will take more time than usual to filter down into the broader economy. This owes to the fact that farmers have become more inclined to pay down debt, such that it won’t be until this deleveraging ends that the income boost translates to higher spending and new investment. But the focus on balance sheet repair will not continue indefinitely.
The sheer size of the income boost, and its positive impact on farm revenues and cash flows, should mean that at least some of the income injection will filter through to the broader economy. This we suspect will start to occur in coming quarters amid early signs the rural property market has started to stabilize.
(Updated with Bill English comments, interactive chart below; More detail; Currency reaction, link to call for currency intervention; Details from research paper; charts from research paper; reaction from JP Morgan economist Helen Kevans)
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