A Dairy Terms-of-Trade Boom in a Small Open Economy
Fonterra has lifted its farmgate milk price forecast from $6.50 to $9.20 per kg of milk solids, adding roughly $4 billion to forecast dairy export receipts. Dairy accounts for about 35% of New Zealand's goods exports. The trade-weighted exchange rate has appreciated 7% since the forecast revision, and the Reserve Bank has held the OCR at 5.5% with annual CPI inflation at 4.2% (non-tradables 5.6%, tradables 1.4%). The government projects an operating balance before gains and losses of 1.8% of GDP. Manufacturers of machinery and processed foods report order books down 9% year-on-year and are lobbying for a lower OCR. The Treasury is debating whether to bank the additional tax revenue in the New Zealand Superannuation Fund or to fund a temporary investment allowance for non-dairy tradable firms.
1. Explain the transmission mechanism by which the dairy price increase could generate Dutch disease symptoms in the non-dairy tradable sector, and assess how the exchange rate regime and monetary policy setting shape that transmission.
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Mechanism.
- Spending effect: higher dairy incomes raise domestic demand, including for non-tradables such as housing and services. Non-tradable prices rise, so the real exchange rate appreciates.
- Resource movement effect: factors (labour, capital, land) shift into dairy and support services, bidding them away from other tradables.
- Exchange rate effect: export revenue converts to NZD, raising demand for NZD; the nominal exchange rate appreciates (7% TWI). This reduces the NZD price of exports and the competitiveness of import-competing and export firms.
- Result: non-dairy tradables face lower revenues and higher domestic costs, contracting. Machinery and processed food order books down 9% is consistent with this.
Role of the exchange rate regime. With a floating rate, the adjustment occurs through the nominal exchange rate; monetary policy is independent. If the Reserve Bank were tightening to control inflation, further appreciation is possible. A fixed rate would force inflation or reserve accumulation instead. The float speeds adjustment but concentrates the pain in tradables.
Monetary policy. With CPI at 4.2% and non-tradables at 5.6%, the Reserve Bank cannot ease without risking inflation. The OCR at 5.5% is restrictive; cutting would depreciate the NZD, helping tradables, but would amplify domestic demand and inflation. The bank faces a trade-off; the appropriate response is to keep policy restrictive and let fiscal policy handle structural adjustment.
Nuance. Dutch disease is not a disease if the boom is temporary and saving is high; the real appreciation is an equilibrium response. The policy question is whether the non-dairy tradable sector has lasting externalities (learning, agglomeration) that justify intervention.
2. Evaluate the Treasury's two options - banking the revenue versus a temporary investment allowance - using both stabilisation and long-run growth criteria.
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Stabilisation. Banking revenue (to the New Zealand Superannuation Fund) withdraws demand from the economy, offsetting the spending effect and reducing pressure on non-tradables and the exchange rate. It is counter-cyclical and builds buffers for future downturns. An investment allowance for non-dairy tradables increases investment demand and may further pressure domestic resources, partially offsetting the desired contraction; it could also support the traded sector's supply capacity.
Long-run growth. Banking preserves national saving but does not directly address the tradable sector's productivity. An investment allowance could raise capital intensity and productivity in non-dairy tradables, but carries risks: (i) picking winners, (ii) administrative complexity and deadweight, because firms may invest anyway, (iii) the allowance may be capitalised into the price of capital goods, (iv) it does not solve the exchange rate competitiveness problem. If there are positive externalities from tradable-sector learning or agglomeration, a temporary, well-targeted subsidy may be justified, but the evidence for such externalities is contested.
Evaluation. Banking is the safer stabilisation tool; the allowance is a supply-side instrument misused as a demand tool. A better package is to bank the revenue and use a small portion for public goods that raise tradable-sector productivity (R&D, infrastructure, skills) rather than a broad allowance. If the allowance is used, it should be temporary, capped, and conditional on additionality.
3. Critically assess whether the Reserve Bank should cut the OCR in response to the squeeze in non-dairy manufacturing.
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Arguments for a cut. Non-dairy manufacturing is contracting; a cut would depreciate the NZD, improving competitiveness. If the contraction is large and persistent, it could reduce employment and potential output.
Arguments against.
- Inflation is 4.2%, above the 1-3% target; non-tradables inflation is 5.6%. Cutting would add demand and could de-anchor expectations.
- The exchange rate appreciation is an equilibrium response to a terms-of-trade shock. Trying to offset it with monetary policy would require inflation to rise; the Reserve Bank cannot target the tradable sector.
- The OCR is a blunt instrument; fiscal policy is better suited to structural adjustment.
- The dairy boom may be temporary; easing now would require sharper tightening later.
Verdict. The Reserve Bank should not cut solely to help manufacturers. Its mandate is price stability. The appropriate response is to keep policy restrictive while fiscal policy addresses the distributional and structural consequences. If the exchange rate is a concern, macroprudential or fiscal tools are better targeted. A cut would trade a modest competitiveness gain for a larger inflation risk, which is a poor trade under the current inflation configuration.