We didn't get it wrong: Wheeler

Graeme Wheeler says the dramatic drop in dairy export prices had not been expected. Photo / Mark Mitchell

Reserve Bank chief cites dairy prices, migration figures among reasons for turnaround on OCR.

"Not at all" was governor Graeme Wheeler's response when asked on Thursday if the Reserve Bank had made a policy mistake last year in raising interest rates, at least half of which it is now on course to reverse.

When the bank began tightening in March last year, the terms of trade were at 40-year highs (and expected to decline only modestly), net immigration was increasing rapidly and the bank was forecasting a positive output gap.

Wheeler said he did not think any forecaster foresaw that export dairy prices would more than halve since then.

While that was partially offset by an equally steep fall in oil prices, oil represents a much smaller share of imports than dairy products do of exports.

International oil prices have risen about 30 per cent from their trough last January, while dairy prices continue to languish.

The current price for whole milk powder is about US$2300 a tonne and, based on forward prices, the bank expects it to get to about US$2700 a tonne by early next year then gradually get back to around US$3500 over the following two years - still well below the US$5000 levels of 2013.

"But it is hugely volatile," Wheeler said. "There are some big variables here, like quotas coming off in Europe - how much will the Irish and other producers respond to that - the Russian import ban [against European product] and the trade diversion resulting from that," he said.

"There is more drying capacity in the United States, and that is all for export, and for the first time in seven years the Chinese have increased their domestic production."

A weaker outlook for the terms of trade, and with it national income and domestic demand, is the main reason the bank cited for its official cash rate cut from 3.5 to 3.25 per cent on Thursday.

Another thing the bank's forecasters got wrong in March last year was the strength of the inflow of migrants. They were expecting it to peak at a slightly lower level than during the 2002/03 surge. It has turned out to be substantially higher.

The bank says the composition of the immigrants - more single workers recruited for the Canterbury rebuild and more students - has meant that the boost to the supply-side capacity of the economy has been faster and stronger, and the effect on demand weaker, than headcount alone would historically have indicated.

Wheeler said the net gains from migration had accounted for about half of the strong 3.25 per cent increase in the labour force over the past year, with a higher participation rate and natural increase providing the rest.

That increase in the labour supply had kept pace with the increased demand for workers, holding the unemployment rate up and keeping wage growth low.

Combined with capital investment by business it means that it has taken a couple of years longer for the slack in the economy to be taken up and the output gap to turn positive than the bank expected when it started tightening last year.