KEY POINTS:
Only a day after intervening to lower the exchange rate, Reserve Bank Governor Alan Bollard spoke yesterday about the high dollar's role in dampening inflation pressures.
In a speech to the Waikato Grasshoppers he spoke of the potential inflationary effects of the projected $2 billion boost to dairy farmer incomes next season - both through direct spending and through wealth effects and equity withdrawal if it resulted in higher land values.
These "two strong" influences on inflation would be "partly" and "to some extent" offset by the strong exchange rate, Bollard said.
The high dollar would dampen medium-term inflation pressures by suppressing activity in those exporting sectors not lucky enough to be receiving high commodity returns.
He stressed that the rising trend in commodity prices in general, and dairy product prices in particular, was very good news for the economy, offering better terms of trade, higher growth and a reduced trade deficit.
Over the past year dairy prices have increased by 73 per cent.
On the demand side, rising incomes in emerging markets had led to improvements in diet, incorporating more meat, eggs and milk, he said.
The strongest growth in consumption of dairy products was in Asia, especially China.
At the same time supply from traditional dairy exporting regions had been hampered.
In Europe, the elimination of export subsidies for milk powder had encouraged farmers to shift to higher-value products like cheese for local markets.
In drought-ravaged Australia, dairy production is well down on last year. Bollard said it was unlikely production would ever fully recover to pre-drought levels. In the United States, booming demand from bio-ethanol producers has pushed up prices for corn, the main source of livestock feed, more than 50 per cent over the past six months.
As the ratio of milk prices to feed prices (for grain-fed cattle) worsens there is less incentive to increase dairy output. The conversion of US acreage to biofuels production meant that a country like New Zealand, which produces animal protein from pasture had a big competitive advantage, Dr Bollard said.
As a result of the biofuels boom any increase in dairy supply could rest on the prospects for emerging producers such as Argentina, the Ukraine and China itself. "It is certainly possible we could be heading into a new era for dairy prices," he said.
While dairy products looked set to be the star performer, the outlook for meat and forest products - the second and third largest export commodities - looked increasingly favourable.
Strong Asian demand had been pushing up log prices since 2005 and Russia was about to ramp up an export tax on logs over the next three years.
Beef and lamb prices had been under pressure as drought conditions overseas led to higher than normal slaughter rates.
"But, of course, higher slaughter now means lower slaughter later."
In the meantime, the pressure on sheep and beef farmers made a fresh wave of dairy conversions all the more likely.
"Before the recent dairy price increase dairy farm prices were looking top-heavy and hard to justify on the basis of expected payouts," he said. "The commodity price increases may have saved some farmers from difficult liquidity positions."
If dairy prices stayed at high levels there would be losers as well as winners. "Higher world commodity prices are typically associated with a higher exchange rate. And while the recent appreciation in the exchange rate has dampened returns to dairy farmers to a degree, it has, at the same time, effectively distributed some of those income gains to consumers via lower import prices," he said.
The increase in commodity prices was heavily concentrated in the dairy sector and the higher exchange rate had reduced returns for many other exporters, including other farmers.
"'This phenomenon is known as the Dutch disease. Very high prices for one export sector can crowd out competitiveness in other export sectors."
MILK MUSCLE
* The dairy boom is good news for the economy, even if it makes the Reserve Bank's task harder, says Alan Bollard
* We may be entering a new era for dairy prices
* As Asian incomes rise so does demand, while lower subsidies, and competing demand for corn from the biofuels industry, dampens the supply side
* The risk is that it crowds out other export sectors.
