KEY POINTS:
Interest rate stability could depend heavily on how long dairy prices remain at record highs and whether farmers decide to spend or save their bounty.
Reserve Bank Governor Alan Bollard raised rates another 25 basis points to 8 per cent yesterday, the third increase this year, putting part
of the blame on the meteoric rise in global dairy prices over the past six months.
The higher prices are expected to add almost $2 billion to dairy incomes in the next two years.
"The rise in dairy sector incomes will provide a substantial boost to economic activity over the next few years, but will also add to inflation pressures," Bollard said.
Dwindling dairy production in the European Union, United States and Australia paired with growing demand in Asia and the Middle East has sent dairy prices soaring and skim milk powder now fetches up to US$4500 ($5964) a tonne.
"Our on-balance view is that dairy prices are likely to remain around current levels for at least the next year or so," Bollard said.
A similar outlook led Fonterra to raise its payout for this season by 20c to $4.35 a kilogram of milk solids and forecast $5.53 next season, but there is much uncertainty about what farmers will do with their windfall.
Although milk and milk-based products are factored into the consumer price index, the bank doesn't expect much in the way of a direct price effect.
Instead the bank is most concerned about whether farmers - who can expect an extra $140,000 going by next season's forecast - will pay off debt or spend up large, which could "add to domestic demand pressures at a time when resources are already stretched", Bollard said.
"A lot will depend on how dairy farmers behave - how much they save and how much they go on a spending spree.
"We will be talking to rural suppliers ... and so on to find out what is going on."
The bank also fears expectations that incomes will keep rising could push up land prices. "This would encourage some existing farmers to withdraw equity from their farms either by borrowing against the value of their farm or by selling it, with the purchaser probably borrowing to fund their purchase," Bollard said in yesterday's monetary policy statement.
"This farm equity withdrawal will provide additional funds for spending."
An increase in spending on cheap imports through a high exchange rate could also fuel inflation.
However, Goldman Sachs JBWere economist Shamubeel Eaqub believes the Reserve Bank has got it wrong, suggesting the strong payout increases could be offset by extreme hardship among sheep and beef farmers and also manufacturing in general.
"Dairy incomes are going to be almost $2 billion higher and that's going to have multiplier effects to boost the economy - [but] similarly sheep farmers are going to be making losses and that's going to have multiplier effects as well."
Eaqub says that while it is uncertain how dairy farmers will use their money, he expects a fair degree of consolidation of debt in light of dramatic increases in rural land prices.
"A lot of farms would have been running into increasing debt to cover their position in the last season."
However, ANZ chief economist Cameron Bagrie said that even if half of the extra funds were saved and half spent, it would still mean an economic injection worth 0.5 per cent of gross domestic product.
And for the country to benefit from "this big economic windfall", global dairy prices would have to be sustained.
The bank was saying this would make its job more difficult.