ECONOMICS : Flow-through Effects of Rising Dairy Prices

Rising dairy prices weren’t the only inflationary force taken into account when Reserve Bank governor Alan Bollard raised the official cash rate to eight percent on 7 June. Government spending, the robust housing market and pick-up in the pace of economic growth and inflation among New Zealand’s main trading partners were also factors.
The dairy sector and its effects on monetary policy nevertheless were the focus of special section in the latest monetary policy statement. The Reserve Bank explained why there’s downside to the 60 percent lift in world dairy prices which has been boon to the local dairy industry over the past six months. Sure, this rise in prices is “clearly favourable development for New Zealand”, the RBNZ acknowledged: it will pump an extra $1.5 billion into dairy farmers’ incomes, through the increased 2007/08 payout forecast by Fonterra, and it will help in much-needed rebalancing of the economy towards the external sector.
But 60 percent rise in dairy prices in six months amounts to terms-of-trade shock which affects inflation through several channels. For starters, there’s the income effect – farmers will want to spend at least some of the boost to their incomes. This will add to domestic demand pressures at time when resources are already stretched. Extra pressure on domestic resources means greater pressure on medium-term inflation, the extent of the mischief depending on how much of the extra farm income is saved and how much is used to repay debt.
Then there’s an asset price effect. The RBNZ is bothered about the risk that higher rural incomes will fuel higher rural land prices. re-acceleration in land prices risks adding to domestic demand pressure through wealth effects and the withdrawal of equity.
The exchange rate effect flows from higher world prices for the country’s commodity exports typically being associated with stronger Kiwi dollar. This tends to dampen medium-term inflation pressures by blunting the competitive edge of firms in other parts of the tradeables sector and boosting imports. The high exchange rate also redistributes some of the gains from higher dairy prices by boosting the country’s purchasing power through cheaper imports.
Most obviously, there’s the direct price effect. Changes to world dairy prices may be passed through to domestic dairy product prices. Milk and milk-based products are part of the consumer price index, and increases in domestic dairy prices – says the RBNZ – “are likely to have prompt effect on CPI inflation”.
The Reserve Bank expects the direct-price effect to be relatively small. Maybe. Consumers by now are likely to be getting an idea of its impact.
In early June, Fonterra confirmed that retailers were preparing to announce raft of increases in the prices of dairy products. This country is not alone. The same thing has been happening in the United States, where forecasters were warning that consumers could expect sharp increase in dairy prices during the northern summer.
In the United States, these increases were being driven by the higher costs of transporting milk to market and increased demand for corn to produce ethanol. Corn is the primary feed for dairy cattle. Companies that use milk, cheese and other dairy products were bracing to spend more on inputs for the rest of this year.
Among them was Hershey, the country’s biggest candy maker, which has scaled back its earnings expectations for the year, partly because of higher dairy costs. Kraft Foods raised prices earlier this year on some dairy-based products and Domino’s Pizza was expecting to pay more through the rest of the year for the cheese it melts on top of its products.
Competition among retailers might be the best guard against rapid increases in dairy prices, according to the American Milk Producers Federation. But in this country, Fonterra was limbering up to minimise the forces of competition.
The effect of Supreme Court ruling in case brought by the Commerce Commission was to oblige Fonterra, the dominant player by far in the dairy industry, to charge independent rival processors price for raw milk which more accurately reflects the price it pays its own shareholding farmers for their raw milk. Commission general manager Geoff Thorn said this would enable independent processors to compete with Fonterra on level terms, contributing to competitive dairy markets and potentially to lower prices for consumers of dairy products.
A spokesman at Open Country Cheese said getting Fonterra to be reasonable had been tough, and “all we want is that healthy competition be allowed to exist”. But as this column went to press, Fonterra was preparing to ask the Government to review the regulations on which the court had ruled “as matter of urgency”.

Bob Edlin is regular contributor to Management.

Visited 23 times, 1 visit(s) today

New CEO at Phoenix Recycling Group   

Phoenix Recycling Group has appointed Phil Hand as its new chief executive officer. The company says Hand brings a wealth of knowledge from New Zealand and Australia’s manufacturing and primary

Read More »
Close Search Window