Long term forecasts come with hidden risks

Long-term forecasts are not precise due to events such as droughts or earthquakes.

Many of the strategic decisions farmers (like other business owners) must make are based on an outlook that extends far beyond the next season. Accordingly it can be useful to stop, take a step back and review the bigger picture. For example, where might interest rates and exchange rates be headed over the next decade?

We should be clear at the outset, that attempting to answer such questions clearly comes with a few health warnings. Long-run forecasts are not precise predictions. In reality the economy will be thrown in one direction by surprises we simply can't see coming - we can't forecast droughts, disease outbreaks, or earthquakes just to name a few such surprises.

But that doesn't mean long run forecasts can't be useful. They are a way of outlining our assumptions for how the current cycle might play out and give some basis for planning, given what we do know today.

The good news for New Zealand farmers is that we remain firmly optimistic on the longer-term outlook for global food prices (though volatility will remain a feature and prices are set to come under downward pressure in the near future as supply increases).

The rapid growth of Asian demand, changing appetites and consumption patterns as well as increasing incomes of consumers in this part of the world, all point in favour of New Zealand's competitive strength as a food exporter. This view in turn means we expect the NZ dollar to remain relatively high against the USD. We expect it to average around 71 cents over the next decade compared to 73 cents over the previous one.

In contrast, interest rates are expected to be lower on average over the next decade than they were over the last one. But that's not to say they will stay as low as they are now. Indeed, the start of the inevitable tightening cycle is creeping closer.

The domestic economy is gathering momentum. Consumers are spending on the back of a buoyant housing market, the construction sector is going from strength to strength and businesses are more optimistic than they have been in years (with this increasingly reflected in investment and hiring decisions).

Add to this an impressive recovery in the agricultural sector after last summer's drought and it's looking like GDP growth will be very strong over the next year. This pickup in activity will eventually have the economy bursting at the seams, and inevitably lead to rising inflation. We expect the Reserve Bank to respond by start hiking the OCR from April next year.

But by 2017 the situation will have changed. The pace of the Canterbury rebuild will be slowing and the economy will be responding to higher interest rates. The RBNZ will embark on an easing cycle.

Just how high the OCR will have to go before it brings inflation back into the RBNZ's target band depends on just what the "neutral" OCR is. That is, where interest rates need to be set in order for the economy to be able to hum along at full capacity without putting upward or downward pressure on inflation. While this speed limit can change (it probably fell in the aftermath of the global financial crisis but will likely increase again as inflation expectations rise, bank funding costs return to more average levels and the recent trend toward more saving by New Zealanders and globally fades) we think it will be about five per cent over the next few years.

So for the RBNZ to be able to put downward pressure on inflation, it will need to raise the OCR above this level. We're forecasting the OCR to peak at 5.5 per cent by the end of 2016.