A continuation of weaker global dairy prices and a high Kiwi dollar might reduce inflationary pressures and lead to the Reserve Bank requiring fewer hikes in interest rates, according to Westpac economists.
The economists are currently picking five rises in interest rates by the RBNZ this year, which after the actual rise last month includes potential further hikes in April, June, July and December. However, they now have a "question mark" over the projected July hike.
The latest fortnightly GlobalDairyTrade auction saw another sizable fall in dairy prices (by 8.9% in US dollar terms).
Westpac senior economist Anne Boniface said it was the biggest fall in a single auction since April 2012, and the fourth consecutive fall. She said Westpac economists had "long been expecting" dairy prices to soften this year.
"For the Reserve Bank, while the drop in milk prices may not be entirely unanticipated either, it does come at a time when the New Zealand dollar is rising strongly.
"This is clearly a combination that will tend to reduce inflation pressure, and if sustained could mean fewer [Official Cash Rate] hikes are required over the next couple of years," she said.
"If the RBNZ was thinking that 200 basis points of hikes are required over the next two years, it may now be thinking more along the lines of 175bp."
On Westpac's projection of OCR hikes this year: "We still believe that the April OCR hike is highly likely to proceed. However, the combination of a rising exchange rate and falling milk prices could put a question mark over the July hike," Boniface said.
On the falling dairy prices, she said: "We wouldn’t advise hitting the panic button just yet.
"We have long been expecting dairy prices to soften in 2014, as producers around the world (including those in NZ) ramp up production in response to the high prices on offer.
"However, as is often the case in commodity markets, after holding up for longer than expected, the speed of the recent fall has been quicker than we had pencilled into our forecasts.
"While this creates a risk that prices could fall further, we remain relatively upbeat on the medium term outlook for demand for dairy, and therefore prices.
"For now we continue to expect WMP prices to remain above US$4000/tonne in the 2014/15 season."
Boniface said it was "difficult to pin the blame" for lower prices on any one particular event and there were probably a number of factors contributing to softer price action.
"Domestically, New Zealand production continues to run well ahead of last year’s levels. This is despite very dry conditions in some parts of the country including Northland and Waikato.
"Farmers are bringing in supplementary feed to offset poor pasture conditions, which is helping to keep milk flowing. However, the dry weather is impacting pasture and stock condition which (depending on weather over the remainder of autumn and into winter) may have implications for production prospects in affected areas next season."
8 Comments
So adverse economic news is good news for ordinary working kiwis with a mortgage?
Who would have thought?, that the 200bps hike forecast might have been unlikely? It was such a sure thing. External events were so unlikely to have any negative effect on the NZ economy.
I think the Westpac economists (even though they are in my view the best bank economists) need to settle down. I wouldn't be changing my monetary policy forecasts on the back of a week of commodity pricing volatility.
While they reckon a milk price drop may soften the need for interest rate rises I think they miss a point Roger Kerr is always quick to point out. Movements in the NZD/USD tend to follow movements in whole milk pricing. it doesn't always happends immediately but it tends to play catch-up, but already the currency pair is down c. 60bps. If it falls meaningfully further it could finally allow for some imported inflation.
Is there some mathematical correlation between a higher than expected exchange rate, milk prices, and the level of the OCR increase or decrease? E.g. can you say that 25bps of OCR is equivalent to a 1% shift in the TWI exchange rate? I note that the TWI has gone up 5% in the last year, and most of that in the last quarter. Imports are roughly a quarter of GDP so although I think most importers just pocket the margin, in theory at least a 5% appreciation in the currency should cause deflation of say 1.25% all else being equal.
I'm surprised therefore that a 5% appreciation plus a very significant drop in milk prices amounts in Westpac's eyes to only a 25 bps effect on the OCR.
We all know that when the bank economists "predict" what the Reserve Bank will do, they are not really making a prediction at all, but price signalling as to what they would like the RB to do. This prediction may or may not be selfserving from the commercial banks' point of view- I suspect it is- but it would seem useful to me if they really believe their arguments, that they explain in mathematical terms why there should only be a 25bps effect.
Unless the rest of the world starts lifting interest rates very soon, it seems to me we are somewhat exposed, and the effect should be more like 100bps in interest rates.
Stephen - they have a model (probably an ex -RBNZ one since all bank economists seems to have spent time there) that inputs various factors that impact inflation (exchange rate is a big one of those) and from that it spits out a projected track for the OCR/bank bill rate. They communicated that to their corporate customers with a ready reckoner type report, and from what I've seen of it, its pretty accurate in regards to what the RBNZ then adjusts its bank bill track to in its MPS out turn - and that's certainly not the RBNZ taking notice of the private sector projections.
Its as simple as that and to suggest that its bank economists doing anything other than trying to forecast for their traders and customers what the RBNZ will do with interest rates is both cynical and wrong.
Grant,
Although I'm not totally convinced, I have no evidence at all to refute your claim, so am willing enough for the most part to give the banks the benefit of the doubt on signalling vs predicting. Are the commercial banks generally more profitable with higher or lower interest rates, and with a rising, stable or reducing exchange rate, or are they indifferent to these variables from a profit point of view? If they have a motive, my suspicions would remain. If there is no motive, then my assumption was very likely incorrect.
On the maths equations between the different key variables of OCR, exchange rates, inflation and current account, it still seems to me the Reserve Bank ends up being over aggressive against inflation- they have consistently undershot now for years, with the exchange rate being the variable they wrongly try to ignore.
Even if they get inflation about right, they do so by damaging trading industries and benefitting importers and house sellers. Apart from the effects on business, in terms of financial stability, a long term more stable currency would be far lower risk. At some stage logic suggests our currency should come down aggressively, especially if milk prices drop dramatically, or if a China slowdown has them pulling money out.
A 5% rise in the exchange rate being equivalent to a 25 bps OCR change just does not pass any sort of sense check.
Stephen - Banks make money when their asset quality, and borrowers debt serving ability, are both strong - add to that, conditions when borrowers sit on floating rates where the banks have bigger margins on average. Contrary to popular belief by one or two here, the last thing they want is deteriorating debt serving (higher interest rates) and customers moving to fixed rates (i.e. they certainly don't have their economists trying to direct customers to fixed rates for banking reasons, other than I guess a desire not to see them hurt if its a sustained run higher) - economists are in the game of forecasting, and that's what they try to do) - in truth though, if rates are going higher chances are the economy is improving and asset prices are rising, so as in all things it's not black and white.
As regards the RBNZ coming down too hard on inflation, it was the exact opposite in the last cycle from 2003 to 2008. Many bank economists were critical at the time that the RBNZ did not move fast or heavily enough in the first part of that cycle ( RBNZ later admitted the mistake), they let inflation get out of hand (to 5%) and then finally realising the mistake, had to try to crush it with an 8.25% OCR. It should never have needed to have got that high if they had acted earlier. Their delays and resultant knee jerk reaction was pushing NZ into a recession before the GFC. They seemed to have learnt from that lesson hence why they only forecasting 5.3% so far this cycle because they may have been more timely on this occasion (although their forecasts don't actually show a top as they only go out to March 2017 currently).
Certainly if the NZD gets too strong, and well above their forecasts that will see a lower OCR forecast track, conversely the likes of an adverse dairy price could put the Kiwi below what they're forecasting, would otherwise push it higher depending upon the impact of that lower price on the economy - many variables.
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