Fonterra warned of volatility ahead for dairy markets as the five-month-old rally in prices began to lose steam.

The New Zealand co-operative, the world's biggest dairy exporter, reported prices once again rallying at its monthly internet auction, with the average price of whole milk powder rising $123 to $3,560 a tonne, its highest for 16 months.

However, the pace of growth slowed to 3.6% month on month, the weakest since prices began in August rebounding from a low of $1,829 a tonne.

The slowdown was particularly apparent in the auction's long-term milk powder contract, for delivery between June and August next year, for which prices grew 0.9%, shrinking their premium over the spot February lot.

Prices of anhydrous milk fat, a milk solid used by bakers, confectioners and ice cream makers, fell for the first time in eight months.

'Supply and demand responses'

The rally was being underpinned by "tight supply conditions", Paul Grave, manager of Fonterra's globalDairyTrade auctions said.

However, he added that while the market had a "positive" outlook, "we expect more volatility as a result of supply and demand responses to this large price increase".

Analysts have warned that the revival in prices is expected to curb farmers' appetite for reducing herds, while encouraging the release of stockpiles built up by authorities in producing regions such as Europe and the US.

It may also encourage a switch in dairy output from products eligible for government intervention buying, such as skimmed milk powder in Europe, to whole milk powder.

Mr Grace added that a sustained revival in dairy prices was "reliant on strong consumer demand", and noted that the economic outlook was still "relatively fragile".