Roger J Kerr reminds us that nearly all our inflation comes from the supply side of the economy, so the impact of lower dairy incomes may not be as pronounced as some fear

 By Roger J Kerr

The plummet in wholemilk powder (WMP) prices and thus dairy farmer milksolids/kg payout levels is causing an increasing divergence of views on future economic performance and thus inflation/interest rate responses.

As of this morning you can take your pick between the return of the perma-bears at NZIER who now forecast no interest rate increases at all in 2015, to BNZ economists who forecast 1.25% of OCR increases in 2015.

Hey, such differences in opinion are what make markets tick.

If all our commodity prices were falling to the same extent as WMP I would agree with the NZIER prognosis.

Clearly, increasing beef and sheep meat prices are providing something of an offset to the plunge in dairy prices.

If I thought there was going to be an immediate and massive rebound upwards in WMP prices I would agree with the BNZ.

The answer, as always, lies somewhere in the middle. We are forecasting 0.75% of increases in the OCR through 2015.

The timing of these increases will be determined by WMP and NZ dollar movements from here.

Current moneymarket forward pricing is somewhere between 0.25% and 0.50% of increases over the next 15 months to the end of 2015.

The interest rate market has once again become too complacent towards future inflation risks.

While the dairy sector is now a dominating part of the economy, just how a reduction in dairy farmer incomes this next year (after a boomer year last season) plays into demand, GDP growth and thus inflation remains to be seen.

Never forget that nearly all of the inflation in New Zealand comes from the supply side of the economy, not the demand side. Therefore the dampening impacts on the economy and inflation from lower dairy farmer incomes may not be as pronounced as some fear.

The outlook for our interest rates over the next 12 to 15 months is a doddle compared to the US Treasury Bond market.

Despite stronger US jobs data and GDP growth numbers which transform through into elevated inflation risks, the US bond yields continue to trade at perplexingly low levels of 2.43%.

As anticipated, the global financial and investment markets have moved on from the geo-political risk events that have dominated sentiment over recent months.

It does appear that the weight of cash being printed these days by central banks in Europe and Japan is holding global bond yields at super low levels and the US bond yields just cannot increase in this environment.

A change in wording on monetary policy settings from Fed boss Janet Yellen still stands as the likely game-breaker that sends US long-term interest rates higher. 

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Roger J Kerr is a partner at PwC. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com