April 20, 2022
Inflation, Interest Rates & the Cost of Farm Inputs
What really is inflation? How is it measured? What is the potential impact on consumers and the ag sector? Purdue agricultural economists Brady Brewer, Michael Langemeier, and James Mintert discuss these questions and the potential impacts of rising inflation & Fed policy on interest rates. Near the end of the conversation, they discuss the long-run relationship between inflation and farm input prices. Slides and a transcript from the discussion can be found below.
Trends In General Inflation And Farm Input Prices, by Michael Langemeier
Intro [Recording date: April 19, 2022]
James Mintert: Welcome to Purdue Commercial AgCast, the Purdue University Center for Commercial Agriculture Podcast, featuring farm management news and information. I’m your host, Jim Mintert, director of the Purdue Center for Commercial Agriculture. And joining me today are Brady Brewer, who’s an Associate Professor of Ag Economics here at Purdue, along with Michael Langemeier, who’s also a Professor of Ag Economics at Purdue.
We’re going to discuss the drivers of inflation in the U.S. economy and what that might mean for interest rates and a little bit about the ag economy itself in terms of the overall impact. Michael, you’ve taken a look at this and I think it’s a good time to maybe just think about some definitions because that’s always a little bit of a challenge. I think when I read the popular press, a lot of times I see some confusion about what inflation really is.
Michael Langemeier: There’s a lot of confusion regarding inflation. Looking at a textbook definition, inflation represents a decline in purchasing power of a currency over time. Also, let’s talk a little bit about quantitative estimates. There are several quantitative estimates of the rate of inflation. This also does create some confusion. These are typically made by examining the increase or decrease in the price levels of a basket of selected goods. That’s very important. That last part of that sentence. It’s a basket of selected goods. So, we’re not just looking at oil prices. We’re not just looking at food prices. If you’re looking at consumer price index, for example, you’re looking at a basket of items that a consumer would purchase. Also, it’s important to note that most economists would agree that an increase in the supply of money is the root cause of inflation. Many of us were told that inflation is a monetary phenomenon.
James Mintert: Yeah, I think that’s paraphrasing a rather famous quote from Milton Friedman. I think Milton said something along the lines of inflation everywhere and always is a monetary phenomenon, as I recall. So, we’ll talk more about that in some detail here.
You know, Brady, I think the reason we’re doing this podcast is the fact that there’s been a big shift in at least one of the measures of inflation, namely the Consumer Price Index.
Brady Brewer: Yeah. So as Michael said, we measure inflation through, you know, looking at what it costs for a basket of goods. And there’s very different baskets we can use to measure that. One of the most common, which is published by the U.S. Bureau of Labor Statistics, they really release two main CPI indices. One that has all items and then one where they actually exclude food and agricultural products as well as energy products. And the all-item category, the most recent numbers just went right over 8.5%. And this has been a sharp increase over the last 12 months. In April of 2021, it was under 2%. And, you know, this is what is causing a lot of the worry about inflation is this sharp increase over the last 12 months. And namely, if you look over the history of what inflation has traditionally been measured by, the Federal Reserve, typically has set a goal of about 2% inflation. And some economists made some comments about this seemed more like a ceiling than a goal of what they wanted inflation to be. Well, obviously, we have gone through that ceiling almost four times over the past year.
Historically, though, you know, I do want to mention this 8.51% of the most recent Bureau of Labor Statistics, CPI indices, while it is high, it’s not the highest we’ve ever seen. If you look back to the 1970s and 1980s, we did have inflation above 10% back in that time period.
James Mintert: And of course, that’s what people are worried about, right. Is the possibility that we might see a reoccurrence of those high rates of inflation. That’s really what stimulated so much of the discussion here the last few weeks. And in the last few months.
Brady Brewer: Absolutely, no one wants to go back over that 10% inflation.
James Mintert: So, Brady, just for clarity, when you say 8.5% inflation, is that compared to a year earlier? Is it a 12 month change that we’re talking about?
Brady Brewer: Yes. So, the most recent data was from March of 2022, you can interpret that as that basket of goods was 8.5% higher than it was in March of 2021.
James Mintert: All right. Let’s talk a little bit about measures of inflation versus inflation itself. Michael, you mentioned inflation is a decline in the purchasing power of a currency. Another way to think of that is to say it’s a change in the price level of the entire economy, right, of all the goods and services in the economy. The challenge of course is there’s no way to measure the prices of all the goods and services of the economy. So, what we have are a lot of different measures of inflation, which are simply proxies for the true underlying inflation rate. And it’s difficult to do a good job, right. The one that Brady was talking about, the CPI, as he mentioned, is published by the Bureau of Labor Statistics, that’s based on approximately 80,000 products. So, it’s a big bunch of things, a big basket if you will. And they update that periodically, I think every couple of years or so. But it’s kind of renowned for being a little bit rigid in terms of the updates. The largest product categories in the CPI are, first of all housing at 32% of the index, food at 14%, and then transport commodities such as cars at 8%. And then after that, you get a lot of smaller items in there. But one of the challenges with the CPI is it suffers from something that I think consumers should be very familiar with, and that is substitution bias. As prices of individual items change, you don’t automatically continue to buy the same things over and over just because you have the habit of doing that. As those relative prices change, people start to substitute and make changes in their purchasing habits. And that substitution bias, which is the failure to account for the fact that people change what they buy over time, often causes the CPI to overstate the inflation rate. That’s always been kind of a long-term controversy with respect to measuring inflation.
So, let’s talk a little bit about some of the substitute measures or alternative measures of inflation that people use to maybe try and get a better grip on the underlying core rate. There is the chained index which is essentially kind of a smoothing process. I think the most recent observation of that one, instead of 8.5, Brady, was I think 8.1%. The chained index, the PCE chain, Personal Consumption Expenditure Index, I think it came in at 6.7% most recently. And then the one that’s probably maybe used more by economists, not so much by the general population or the business press, is one of the measures of core inflation, which is called the Trimmed Mean PCE. That’s a measure invented a few years ago, I think, by the Dallas Federal Reserve Bank economists. And it’s an attempt to measure the underlying rate of inflation and maybe to stay away from or avoid some impact from shifting supply demand fundamentals which can influence these measures of inflation. I think the most recent measure of it in February was just up 3.6%. So, what’s your take on that, Michael? You were talking about the fact that there’s this difference between changing fundamentals, shifts and true supply demand curves, for example, for individual items, versus this inflationary impact. How do you kind of view those?
Michael Langemeier: Well, I can tell you a little bit on which one I tend to use. I tend to use the implicit price deflators, which does not suffer as much from the bias as the CPI. But specifically, I like to use the implicit price deflator related to personal consumption expenditures. And the reason why I do that is we’re all consumers. And even if we’re producing a product like a farm, we’re still consumers, and so we take everything back to the consumer level. And so that seems to me to make sense as a good way to measure inflation. But having said that, the inflation indices are very correlated. Yes, they are a little bit different in the magnitudes, but they’re very correlated over time. And so, if you’re tracking inflation over time, you’re really getting a similar picture regardless of the measure you use.
Let’s talk a little bit about inflation mechanisms. And this is straight from a textbook, a macroeconomic textbook that would be talking about inflation. Economists typically say there’s three different types of inflation: demand pull inflation, cost push inflation, and built-in inflation. So, let’s talk a little bit about these in turn, then talk about which one of these are probably more important than the other ones. When you look at demand pull inflation, what you’re really talking about is have we increased the money supply to such a degree that the demand for goods is higher than the productive capacity of an economy? And so, for example, if we have a large stimulus and so there’s a lot of money out in the economy, perhaps we’ve put more money out in the economy than our increase of productive capacity during a period of time. That’s going to result in what we call demand pull inflation. And it’s certainly pertinent to the recent surge of inflation. Another type of inflation, which I don’t think is quite as pertinent as demand pull inflation, is what they call cost push inflation. This is when production costs increase prices. The way I think about this is not so much that firms use increases in production cost to raise prices. That’s not how I think about cost push inflation. I think about technological changes for example. If we have technological changes that actually result in deflation or a reduction in inflation. So that’s how I think about cost push inflation. Also, as you improve the quality of a good, for example, human capital or your farm employees, employees of any industry is really improved over time because of more experience, more training, more education. That improves the quality of labor. And so that positively will impact the price of labor. And so that’s how I think about cost push inflation. Also, a very important type of inflation, once we’ve had some inflation, is what they call built-in inflation. And we’re getting some of this today, in today’s environment. We’re going to talk more about this later in the podcast. But when individuals expect current inflation rates to continue in the future, we have built-in inflation going on. Think about wage negotiations, if we’ve had 5% inflation recently, that’s going to be an important part of the negotiating process in next year’s wage contract. And so that’s what I mean by built-in inflation. And so, I really think demand pull inflation when we have this increase in the money supply that’s increased demand more than the productive capacity and built-in inflation are two of the main reasons why we’re seeing this recent surge in inflation.
James Mintert: So, Michael, I would disagree a little bit with your terminology, not necessarily with the scenario that you laid out there. But when I think of inflation, it’s really about the money supply. Stimulating the demand in the economy beyond the increase in productive capacity, as you mentioned. And then I would argue the cost push and the built-in aspects that you mentioned, those are real, but they’re really a reflection or a movement through the economy that was originally caused by that increase in the monetary base and to some extent fiscal policy, which increases the monetary base as well.
Michael Langemeier: Yeah, we don’t disagree that much. I think the demand pull is the major driver.
James Mintert: That’s the driver. The other two are really kind of results that kind of trickle through the economy over time and maybe continue to exacerbate the problem. But they’re not the underlying problem. And I think that’s a kind of important point because when I think about some of the rhetoric that’s taking place, particularly in legislative arenas, they’ve tended to focus on things like cost push. The real problem is the first cause, which is the demand pull created as a result of the monetary stimulus that took place. Right. So, I think that could create some confusion from a policy standpoint. Brady, what do you think?
Brady Brewer: Yeah, and just to clarify, I think a good example of this is if you think about what happened during COVID and the stimulus packages that went through, obviously there was a sharp increase in spending, namely on platforms such as Amazon and other delivery services. This created a backlog of shipping around the world. We heard stories of boats being docked outside the L.A. port for 2 to 3 weeks. Obviously, that raised the cost of shipping across the oceans around the world. And that was really a direct result of the demand pull. We were ordering more. We weren’t going to shopping centers to purchase it. We were going through online delivery services. I realized some instances that those packages still had to get shipped across there, but it stuffed certain channels. That increased some of those supply chains, the cost of getting those goods around the world. So that cost push was in my mind a direct impact or direct result of the demand pull inflation.
James Mintert: Yeah, I think that’s a good point and a good way to look at it as well. So, if you think about it, you know, we were looking at some literature here, I guess earlier today and it was interesting to me as I was kind of leafing through online anyway, some older issues of The Economist magazine. And I ran across an article that they published back in April of 2013, and the title of the article was The Death of Inflation. And I thought it was particularly relevant here nine years later to think about, well, what’s changed? And the article did a nice job of explaining what happened in the 1970s and how that differed in two major economies, the American economy versus the German economy. And this is really based on a study by the IMF, the International Monetary Fund. And essentially what they looked at was how the central banks in the U.S. versus Germany responded to an increase in inflation in the 1970s. The German central bank, the Bundesbank, did not accommodate what was taking place by having a very stimulative monetary policy. Whereas the Fed in the U.S. continued to have a pretty stimulative pretty loose monetary policy in the 1970s and actually exacerbated the problem. And so, by the time the late 70s came along, we were looking at double digit inflation rates. And finally, there was enough concern among the general population to maybe make inflation enemy number one, I guess, is a good way to think of it. And that really is what happened when Paul Volcker became chairman of the Fed. And it was pretty clear that his job as chairman of the Fed was to reduce the inflation rate. And he knew and a lot of other economists knew when he was given the license to do that, it was going to be painful. And a lot of our listeners remember all too well what happened in the 1980s. We had high inflation rates. We stamped it out with high interest rates. Very high interest rates, and in particular, agriculture really suffered from those high interest rates. So that was a big challenge going forward.
So, let’s think about what’s going on now. All right. Let’s think about that was that was kind of the explanation for what happened in the 70s and a little bit of the early 80s. As we as we move through, where are we at now? And, you know, Michael, one of the challenges we’ve got now is how high do we have to raise interest rates to reduce the inflation rate?
Michael Langemeier: Yes. And this is problematic for two reasons. First of all, we’ve kept interest rates very, very low since 2008 because we’re worried about the economy. And so we’ve got interest rates that I would claim that some people would argue artificially low. And what I mean by that is they’re below an equilibrium interest rate, if you will. And so they are artificially lower and lower than this long term equilibrium interest rate. And so, in some aspects, we need to increase it up to that natural rate or that equilibrium rate. And then probably, if inflation remains relatively high, we’re going to need to boost it even more to get the interest rate above the inflation rate. And so, you start adding that up and you’re talking about some potential for some pretty large increases in interest rates.
James Mintert: And that creates an accompanying set of problems. Right. So, you know, if you think about the extraordinarily low interest rates we’ve had now for a number of years, really going back to the recession, the 2009 timeframe in the recession. What it’s allowed governments to do is to have these very large deficits because they could finance them with very, very low interest rates. Low interest rates are always positive for asset values. Right. Unambiguously, when you think about a model of asset prices, low interest rates prop up those asset prices. And we’ve seen that with things like, in recent years, the rise in housing values. Longer term, we’ve seen it with respect to stock prices. Right. The stock market has been stimulated by these low interest rates. Farmland has benefited from that in terms of boosting values. So, this really creates a challenge going forward, right? Because if you start increasing interest rates, along the lines of what you’ve just outlined Michael, it’s going to have a negative impact on asset prices, right?
Brady Brewer: Yeah, absolutely. If you think about if you’re going to buy a house, right, the higher the interest rate, the higher your monthly mortgages. So as interest rates increase, it directly impacts my purchasing power as a consumer of a house and means that I can now afford less. Which is going to put downward pressure on housing values. Right. You know, for a large part of the population, if you’re buying a house with a mortgage, you can now afford less of a house because your monthly payments are going to be higher with that higher interest rate.
James Mintert: And when you think of that from a market level standpoint, one way to look at that is to say for a given house price level, fewer people can now afford that particular price house, right.
Brady Brewer: And that pulls back that demand pull inflation that Michael was talking about earlier, that curbs that. And also, the other impacts, if you think about how interest rates curb inflation. Right. You know, interest rates may have to rise to sharply combat this inflation. The other thing that interest rates does is it encourages all of us as consumers to keep our money in the bank. Right. As interest rates increase, so does the money we’re getting on our checkable deposits. So, the stock market has to respond as well. The required rate of return to put our money in that stock market has to go up, and it encourages people to spend less in the material goods market and keep it invested, which slows down what we called the velocity of money, which is how quickly money changes hand in the economy. And that in turn slows down inflation as well.
James Mintert: So, you know, if you think about it, Michael, this kind of gets at this idea of why it’s important to have a measure of inflation that’s pretty accurate, right? When you start thinking about having to raise interest rates above the inflation rate, it behooves you to have a pretty good grip on what the true inflation rate is, right?
Michael Langemeier: Definitely, because as we indicated before, there was 2-3% differences in some of those rates. Even the PC and CPI now I think it’s at least a percent and a half, if not 2% difference. Well, that’s a big amount. If you have to increase the rates 2% more if you use that higher inflation rate.
James Mintert: Yeah. So that’s one of the challenges the Fed has is to get a grip on what the inflation rate is versus the impact of price changes because of a variety of things like some of the disruptions we’ve talked about. So that that continues to be one of the issues. So, I think you have to be a little careful about, say, for example, and I think some of our listeners might have been taking this most recent CPI rate and added a couple of points to it and think and that’s how higher interest rates are going to go. I’m not sure I’d go that far because I’m not convinced at this point that the inflation rate is as high as what the CPI, for example, showed using this most recent reading. But it does suggest an upward trajectory on interest rates.
Brady Brewer: Yeah, absolutely. Interest rates are going to increase. And I just do want to latch on to something you just said, Jim, is that, you know, you think that the CPI, you know, may not be as reflective as, you know, that 8.51% may not be as high. One thing I want to remind the listeners is that this is an aggregate measure. So, I hear a lot and see a lot on social media of, well, if you look at gas prices or if you look at one particular measure, you know, without a doubt and we’re going to go through some of the important farm inputs and how much they’ve increased from over the past year. If you take any one particular good, it may be possible that it’s increased 100 or 200%. But also, keep in mind over this, even though we’ve had some pretty steep inflation numbers over the past year, there’s actually some things that have decreased in price. Right, due to technology. Or if you think about like the travel sector, airplanes and stuff like that, you know, less people are traveling, so less demand there. The prices have kind of rebound now, but for a portion, a good part of 2021 or, you know, end of 2021, near the beginning of 2022, there were certain items such as cruise ships per say, where they were practically giving their product away because the demand had decreased. So, keep in mind, this is an aggregate measure. So, while some stuff may have increased 30%, there’s some stuff that may have decreased over this time frame.
James Mintert: Yeah, that’s a good point. So, you know, one of the things that I think economists like to worry about and others are going to worry about down the road is if we boost interest rates a couple of points above the inflation rate, and if the inflation rate is in the ballpark of 5%, which is what several of the measures would suggest, CPI is higher than that at the moment, but some of those core measures are closer to that 5% mark. It’s difficult to reduce or tamp down the inflation rate without causing a recession. I think the last time America’s inflation rate fell from over a 5% rate, without a downturn, was over seventy years ago. So, if we really do have inflation at 5% or so or maybe a little above 5%, and we really want to pull back on it, it’s going to be tough.
Michael Langemeier: That’s why the Fed is purposely choosing to do this in very slow fashion to see if that can tamp down inflation. They’re probably going have to pick it up a little bit if it doesn’t. So, they’re in a tight spot. But that’s why they’re thinking gradual increases in interest rates.
James Mintert: Yeah. So, you mentioned this earlier, Michael. I thought it was interesting to go and look at the University of Michigan’s consumer sentiment survey. One of the things they do is ask consumers what they expect to see in the inflation rate over the next 12 months, over the next year. And also over the next five years. And when you look at the readings over the last year that they’ve been getting, consumers have consistently been bumping up their expectation for inflation. A year ago, they were expecting inflation to be 3.4%. And the most recent survey here, April 2022, 5.4%. So that’s exactly what you were talking about earlier, right? As people build in those inflationary expectations, it becomes more and more difficult to push inflation out of the economy. That you agree with that?
Michael Langemeier: Yeah, that makes it more difficult to plan to. Let’s go a little bit more to the producer level, the Ag Economy Barometer. We’ve seen by asking questions related to input price changes that the expected percentage that they’re expecting input prices to increase here in the last several months. And so that makes it more difficult to plan if you’re a business. Usually when you have higher inflation rates, you have more volatility. So, I want to get to that aspect of high inflation. It is really difficult to make enterprise decisions, to make capital investment decisions when you have a high inflation, particularly if inflation’s volatile environment.
James Mintert: And historically high rates are associated with volatility? Right. All right. So, I think for some of our listeners, you know, we talk about things like the federal funds rate, that’s maybe not a number a lot of us are acclimated to thinking about. I thought it was useful to just go back and look at what’s going on with mortgage rates. So, if you look at the rate on a 30-year fixed rate mortgage, the most recent number and this is kind of a headline number here in the last week or so, that rate has hit 5%. That’s the first time that 30-year mortgage rate has been that high since May of 2010. So that’s 12 years ago. To put that in perspective for some of our older listeners, like I am, that remember those peak mortgage rates back in the 80s? There was a time in the 80s when we had 30-year mortgage rates above 18%. That’s almost hard to believe in the current environment. We were talking before the podcast here, some of us remember buying houses over time. I remember the first house I bought, the mortgage rate was 9.6%. Michael, you?
Michael Langemeier: At least 8%.
James Mintert: And Brady’s little younger so his is not quite so high.
Brady Brewer: Yeah, mine was 4.2%.
James Mintert: Boy, that sounds pretty good, actually.
Michael Langemeier: Sounds really good.
James Mintert: I would have loved to have that 4.2 when I was paying 9.6. But anyway, things have changed a lot and that’s had a big impact on what people can afford and the impact on housing prices.
Brady Brewer: That is one thing, I guess I’ll just make a quick point here. As I’ve heard a lot of, you know I don’t want to call it dire, but fairly negative attention paid to some of these interest rates of how are people going to afford stuff. And I do just want to say, historically speaking, if you look at a 30-year average, we’re still below the 30-year mortgage. You know what the average was over the past 30 or so, even though we’re at 5%, I think what we need to pay attention to is what we’re really honing in on here is where is this going to go? Right. And the answer that I have is, I don’t know. Maybe you guys have the golden answer to where mortgage rates are going to be in 2 to 3 years. That’s really, I think, what the concern is here. 5% is still pretty cheap, if you think about it from a historical perspective of where interest rates have been.
James Mintert: I tend to agree with that. I think, my own experience, this always happens with people, you’re colored by what happens early in your career. And, you know, my memory of those 18% mortgages, my memory of that 9.6% mortgage that I had at one point in time, colors my judgment. Right. And so, when I look at current rates, yeah, we’ve had a big increase, but relative to those historical rates, it’s still not too bad. That does beg the issue. And we’ve been getting this question from some producers here lately, Michael. You know, if you’re in a farm situation, should you refinance? We’ve been talking about that for a number of years and encourage people to lock in long term rates that we thought were pretty attractive. I feel pretty good about that advice over the last few years. Some people wondered about it, because in the short run we weren’t always right because rates continued to decline. What would you do today?
Michael Langemeier: Well, I want to answer that a couple different ways. I’m going go back to what Brady was saying. Another thing to keep in mind here is the current period that we’ve just lived through, where the the mortgage rates were down to 2.5%. That’s the outlier. That’s the abnormally low interest rate. That’s not something we would expect to see for the next 30 years. And so, don’t expect us to return to that anytime soon. Can we live with 5%? Probably. But what we’ve been talking about earlier here, I don’t think it’s going to stay at 5%. I think it’s going to continue to climb and perhaps get up to 6-7% at least. And then it goes back directly to answer the question you were asking, I think there’s a very good chance that we could see a 2% plus increase in long term interest rates in agriculture. And so, you should try to lock in some long-term interest rates if you haven’t done so, even though they’re slightly higher now than they were a year ago, it still might be attractive to lock in some interest rates.
James Mintert: That kind of matches my expectation as well. So, what about you, Brady? Let’s get the third vote.
Brady Brewer: So, I would agree, I don’t think we’re going to return to 2.5% interest rate anytime in the near future.
James Mintert: Yeah, I would take that a little farther any time in the foreseeable future. And you know, if you’re on the bubble, if you’ve been thinking about doing some refinancing or locking in a longer-term rate, I don’t think it’s too late. It’s obviously, you know, you can look at a chart and say, I should have done it six months ago, but I think there’s definitely some upside risk to these rates and so that’s a very serious consideration.
James Mintert: And so, speaking of that, Brady, you’ve taken a look at this. They have the so-called DOT plot. You might first start off by explaining to us what the DOT plot is.
Brady Brewer: So, let me actually first start with what the Fed funds rate is, because I just want to make sure there’s no confusion here. So, the interest rates that we were just talking about was if you went to a bank to get a house or a mortgage, the rate you would get charged. The Fed Funds Rate, while it is technically an interest rate, also called the overnight rate, is the rate at which the Fed loans out money to banks or banks loan each other money on an overnight basis. Okay. While this doesn’t exactly track interest rates, right. This is not banks don’t necessarily set their interest rate off of the Fed funds rate. It is a major component of that. One of the main figures or one of the main items that a lot of banks look at is what is called the spread over cost of funds. Right? So, it’s the spread over what they’re charging their customers, the interest rate for the mortgages and loans that they’re lending out, relative to what the cost their funds cost the bank to get. Sometimes this is a mix of if you think about the checkable deposits, if you put money in a savings account, you’re getting an interest rate on that. But a lot of times we use the Fed funds rate as the cost of funds because if they have to go out and get more money from the Fed, this is what it’s costing them. And if you look at, you know, we mentioned a little bit about the Fed is going to do this in a gradual stair step motion. And that’s historically what they’ve done. They’ve increased it 25 to 50 basis points at a time. Or if you think 25 basis points is equivalent to a quarter of a percentage of an interest rate. Right. That’s what they have historically tried to do. And they don’t want to come in and just shock the economy. Okay. We’ve mentioned several times, this extraordinarily low interest rate environment, if you look at where the Fed funds rate has been over the past ten years, more often than not, it’s going to be at what we call the zero lower bound, which means that we can’t take it any lower. Right, without making it negative, which I assure you the Fed does not want to make the Fed funds rate negative. Right. And that’s, you know, I think a big component of where we can see interest rates headed.
Now, the dot plot. The FOMC Board of Governors, which is made up of a voting committee of the heads of the Federal Reserve Districts and some other policymakers, every time they meet, they survey the FOMC Open Market Committee on where they think the Fed funds rate is going in the near future. So, one year from now, two years from now, three years from now, and then they ask a longer term. The DOT plot represents the median of each person on the FOMC committee where they think it’ll be at that time frame. And as you can see from the DOT plot, if you look in 2024, right, the median guess is right there around 3-4%. But there are people on the FOMC committee that think that the average guess would be around, you know, 4% or north of there. Right. So that means they could in some scenarios, they’re saying that it could be way higher than that. That’s their average guess.
James Mintert: So, let’s back up for a second. If we look at the current federal funds rate, they’ve raised it here recently. It’s still less than a half a percent, right?
Brady Brewer: Yes.
James Mintert: So, we’re looking at the potential to see the federal funds rate move from less than half a percent to go into 3.5.
Brady Brewer: Yep. Over the next three years.
James Mintert: So, a three-point move. And that would probably translate. This is kind of putting you on the spot a little bit. But if I think about things like mortgage rates…
Brady Brewer: Well, we looked at the 30-year fixed mortgage was right around. You know, it got up to 5%. You think about that spread, that means mortgage rates. You know, if we go up to 4% on the Fed funds rate, add in that spread of 4-5%, you know, that puts us right around 9-10%.
James Mintert: Certainly above 8%, right?
Brady Brewer: Yes. And obviously, there’s a lot of factors that play into that market demand, the risk profile of the economy at the time frame, so that the spread is not constant. But if you if you take a very ceteris paribus view, you know, all things equal assumption, and apply the spread to what they’re expecting, yeah, that puts you in that 8-10% range.
Michael Langemeier: I don’t want to serve the as chicken little here, but I think there’s also more upside than what we’re talking about here. I don’t think the people that are on that board necessarily think inflation’s going to stay at 7-8% either. And so, if inflation does stay relatively high, the interest rates we were just talking about would have to be even higher. I do not want to spread fear out there, but there’s a lot of uncertainty right now with where inflation’s heading. And that’s what makes this really difficult for the Fed board to figure this out.
Brady Brewer: Yeah. So, one thing to keep in mind here, and this is not a criticism of the Fed board, but you do have to think about their position and where they’re coming from. The last thing that they want to do when they release the reports is incite fear. So, I’m not saying that you can take that dot plot and say, okay, this is on the low end. But I do think that it is a very conservative estimate of that committee.
James Mintert: So just for a little bit of history, it hasn’t been too long ago that the federal funds rate was just shy of 2.5. So, the idea that it would go to 3, 3.5, 4% is not unrealistic at all. We could probably, in kind of a normal scenario, kind of expect that to happen. I think the biggest concern, this is kind of the raise the point you’re raising Michael, is whether or not to raise it above that level.
Michael Langemeier: And they were at 2.5% when the inflation rate was relatively low. That was to try to normalize the rate coming out of the 2008-2009 recession. And I think they would have continued to increase that Fed funds rate past 2.5 if COVID wouldn’t have hit. And so that was part of that normalization process, they stopped that process primarily because of COVID. The big hit to the economy of COVID, you know, caused a situation where they thought they really needed to decrease that Fed funds rate.
James Mintert: All right. Let’s talk a little bit more about specifically the impact on the ag sector. And you mentioned this earlier, Michael. We’ve been asking people in the Ag Economy Barometer about input price changes. And we’ve been getting back some pretty horrendous numbers. Let’s talk a little bit more about inflation and farm input prices.
Michael Langemeier: Well first of all, it’s very important to note that input prices in production agriculture and in every industry in the economy are partially due to general inflation. So, they do follow general inflation to some extent. But we all know that every input price market, i.e. anhydrous ammonia, for example, has its own supply and demand fundamentals that also impact the price for that input. And so, there’s a difference between general inflation movements, as we’ve said earlier, and change in input price for one particular input. And so, keep that in mind. But having said that, some inputs are more closely aligned or correlated with general inflation. So, let’s talk about that first before we talk about recent changes in input prices. And so, I looked at a long-term relationship between the implicit price deflator for personal consumption expenditures, my measure of general inflation, and agriculture production item input price indices from USDA NASS over the 1973 to 2021 period. What did I find? Well, the PCE and agriculture production items, very broadly defined, this would represent most of the production inputs in agriculture, had a correlation coefficient of 0.6. That’s highly correlated. So, they’re certainly don’t follow a 1-to-1 by any means. There are some fundamentals specific to the agriculture industry, but they’re highly correlated.
Talking about this further, two inputs in particular that are highly correlated with general inflation are wages, that’s not unexpected. Wages tend to be very correlated with general inflation. In fact, in some industries, general inflation is used to negotiate wages. Unions, for example, is the case. Also, Social Security recipients, a big chunk of their increase is related to inflation. So, that link is not surprising. One that may surprise people is there’s also a strong relationship between general inflation and machinery. So that’s also highly correlated. Fuels tend to be fairly highly correlated with inflation, not as high as labor or machinery, but also relatively correlated with general inflation. When you get into things like feed, seed, fertilizer, repair, agriculture chemicals. The correlation is still there. There’s still a correlation between general inflation and these. Then you have feed, seed, fertilizer and agriculture chemicals, but it’s lower. And the reason for that is the seed industry has unique factors that impact the seed prices. Same for the fertilizer industry. For example, the fertilizer industry, you know, is highly correlated with corn and natural gas prices. And so those are very important in setting fertilizer prices. I’m not saying as important, but they’re important in addition to general inflation when you’re looking at the fertilizer market.
James Mintert: So, Michael, when I look at those correlations that you’ve identified, in a way it really is no big surprise that labor and machinery were the two highest, right. You’d expect that in a way, because clearly the general economy is going to have a big impact on what you’re going to have to pay for labor on the farm and also farm machinery.
Michael Langemeier: And I didn’t look at building materials specifically, but it would be the same as those two.
James Mintert: You would expect that anyway. Okay. So, let’s talk about the recent trends, because the recent trends are kind of wild.
Michael Langemeier: This is what we’re picking up in the Ag Economy Barometer, very large expected increases in input prices. They’re (farmers) are looking at these recent increases. And so, let’s take a look at this. When I talk about recent changes, I’m looking at February 2021 to February 2022. I have information for some of the inputs in March 2022, but not for all of them. So, I’m using February 2022 as the ending period. That’s important because the inflation in March of 2022 was high, to say the least. And so using the last 12 months ending in February 2022, it ranges all the way from 0.2% for seed, that’s a USDA NASS input price change of 0.2% for seed, only 2.3% for wages, all the way up to 179% for anhydrous ammonia and 107% for potash. A 100% change would be a doubling. And so obviously anhydrous ammonia and potash have more than doubled in the latest 12 months. And if you talk to producers, that’s the first thing they’ll talk about is the very high fertilizer prices. Also, phosphorus, 18-46-0, is also increased rather dramatically, about 51%. Diesel, 47%. If you include March 2022 for diesel, that would probably increase to 65-70%, because March 2022 we had a large increase in diesel prices. But the bottom line here is if you look at all production items used in production agriculture, kind of an aggregate input price index, the percent change is 15.6% compared to a PCE implicit price deflator, a rate of change of 6.4%. And so, the rate of change has been higher in agriculture than it has been in the general economy. That’s not particularly surprising. Input prices for a specific industry like agriculture tend to be more volatile than they are in terms of general price inflation. Because different items are impacting inflation in agriculture compared to PCE. Why is agriculture so high? Well, I talked about the very large increases in fertilizer and fuel prices, but also agriculture, chemicals, machinery, building materials. All of these have increased at pretty rapid rates, contributing to that relatively high, a change in the input price for agricultural production items.
James Mintert: So, the interesting thing about this to me, Michael, aside from the big increases, is some of those items you mentioned is the fact that there’s only a couple of items on the list that you’ve got here that increased at a rate that was less than the PCE deflator. And those happen to be, as you mentioned, seed and wages. The rest of them were all higher. And as you look at it, sector by sector, you can understand what was taking place there. But it’s had a big, big impact on production costs and has left a lot of people worried about what’s going to happen not only in 2022, but as you and I visit with producers, a lot of people are starting to talk about what’s going to happen in ‘23.
Michael Langemeier: And I do not have the answer for what’s going to happen past 2022. But one thing I do worry about a lot, is something we’ve talked about a couple of times in this podcast, when you have high inflation, you have high volatility. And so, it’s a real concern that some of these input prices changes that we’ve seen recently are going to still persist into 2023. At least the levels are going to persist into 2023. So, it’s a real worry.
James Mintert: We’ll have a little more information on this going forward when we get the results from the Next Ag Economy Barometer survey, because we put a question on there that asks people what they think is going to happen in 2023 relative to 2022, and it’ll be the first time we’ve asked that question.
So, let’s kind of wrap this up and talk about some of the impacts. And Brady, you’ve given this some consideration, so I’ll turn it to you.
Brady Brewer: Yeah, if I’m going to summarize kind of our discussion here that we’ve had on this podcast, you know, really you have two countervailing headwinds here, right. Inflation is making everything more expensive. Right. The PCE is up 6.4%. The Bureau of Labor Statistics, their CPI is 8.51. Obviously at production ag, Michael said it’s around 15% increase. But now you have the Federal Reserve coming in, banks coming in, interest rates put downward pressure on these asset prices.
You know, we don’t have the crystal ball here to know how high interest rates are going to go. We know they’re going to go up from where they are to combat this increase of inflation. But an increase of interest rates puts downward pressure on these asset prices. You know, I think from someone who studies finance, these headwinds tend to impact what I call the tails of the distribution the most. Right. The people that are already maybe credit constrained, the farmers or consumers that may already be struggling to pay the mortgage. Right. One thing that I do want to point out that is different from the 1980s, is that banks have increased liquidity, I’m speaking specifically here to the agricultural banks, but if you look at the Kansas City Ag Finance Data book and the data that they publish, the loan to deposit ratio, which is the amount of loans that the banks have outstanding relative to the amount of deposits they have at the bank, has decreased here over the past year or so. Right. So, banks are pretty well positioned to weather this if we do get into, you know, some liquidity concerns in the agricultural sector. And the other thing is, is that we see increased liquidity in the ag sector from a farm balance sheet perspective. This has shown up in the demand for loans at ag banks has decreased, which indicates that farmers have more money on hand and thus, when they go to the bank to ask for loans, are asking for less amounts of money. To me, this is going to be really interesting to see how these countervailing pressures, i.e. the inflation and interest rates plays out and shows up in the liquidity of the bank liquidity and the farm liquidity here over the next 2 to 3 years.
Michael Langemeier: The good news, Brady, is the farm balance sheet is really pretty solid. Yeah, we’ve got good asset values right now. And so even some downward pressure on land values, if it doesn’t decrease too much, we’re still looking at a very solid balance sheet. Also, liquidity or working capital, is really solid right now compared to what it was even in 2019. The last two years have really built up working capital. And so, we’re starting at a pretty good point. I’m still really worried about inflation volatility in the next 2 to 3 years, but at least we’re starting a pretty solid balance sheet.
Brady Brewer: Yeah, but again, Michael, that goes back to my point is that the tails drive the distribution. If you had the 1980s and I realize that the banking structure, both from a regulatory standpoint and bank structure, because we’ve had a lot of consolidation in the finance sector, is a lot different because what we saw in the 1980s was, you know, all it took was one or two farmers in some bank’s territory to declare bankruptcy. And all of the sudden, the bank was having to tell farmers that they normally would be more than willing to lend money out to, because the bank was liquidity and capital constrained, those farmers were now facing a constraint and it was like a snowball effect. Right. And that’s what we don’t want to see happen. I think that’s why there’s so much fear out there is we don’t want that snowball to start rolling down the mountain. And someone who is creditworthy all of a sudden isn’t because of some of these factors.
Michael Langemeier: Yeah. And, like you said, there are some individuals that have very high debt to asset ratios, fairly low incomes even in these fairly good times that we’ve seen in 2020 and 2021. And that’s what you worry about is that group gets larger as we go through these real relatively difficult times.
Brady Brewer: And that’s what makes measures like these so hard to predict 1 to 3 years out in the future is because a lot of the measures that we’ve discussed here today are the average numbers. They’re not the tail distributions, the people on the fringe, or the data points on the fringe, I should say, which that’s what makes it so hard to predict.
James Mintert: So, as you think about it, you know, I think in a future podcast, we’ll probably spend more time thinking about the impact on farmland values. But I think that’s going to be one of the interesting questions, right? As interest rates increase, what impact that is going to have on farmland values. And obviously, it could be a tradeoff between what’s going on in the commodity markets versus what’s taking place with interest rates. Right. So, we’ll explore that in more detail on a future podcast to look forward to. Maybe inviting one of our colleagues, Dr. Todd Kuethe, who specializes in focusing on farmland values.
So with that, I’m going to wrap this this podcast up. So, on behalf of my colleagues, Michael Langemeier and Brady Brewer, and the Purdue University Center for Commercial Agriculture, thanks for listening. I’m Jim Mintert and we look forward to visiting with you in a future podcast.
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