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Audio Transcript

Brady Brewer: Hi, and welcome to the Purdue Commercial AgCast, the Purdue University Center for Commercial Agriculture’s podcast, featuring farm management news and information. I’m your host Brady Brewer, and joining me today is Dr. Michael Langemeier, Professor of Agricultural Economics and Associate Director of the Center for Commercial Agriculture. On today’s episode, we will be discussing the recent updates to the agricultural credit market.

I just wanna highlight real quick before we get into today’s agenda this information along with other farm management news and updates can be found on the Center for Commercial Agriculture’s website at purdue.edu/commercialag.

Michael, it’s been a while since we’ve done a finance update. We’ve seen some more interest rate increases from the Federal Reserve. Before we get into that let’s talk a little bit about inflation. So where are we on the inflation numbers as it pertains to agriculture?

 

[00:00:59] Inflation

Michael Langemeier: After some pretty bad news in 2022. Some relatively high inflation, both with the general inflation, the U.S. economy, in particular with the agriculture production items, 2023 looks like it’s much better. So let’s review 2022 numbers compared to a 10 year average, and then we’ll get into ’23 numbers. If you look at 2022, if you look at the implicit price deflator for personal consumption expenditures, it increased 6.3%. That compares to a long run average of 2.1%. So obviously, it was quite high, but agriculture production items overall using USDA NASS information increased 17.0% in one year.

In fact, break even prices for corn according to the Purdue budgets were up 25% in ’22. And so obviously ’22 was extremely high in terms of inflation and increases in agriculture production items. That compares to a long run average increase in agricultural production items of only 3%. And of course most inputs were up in ’22, but in particular fertilizer and diesel. So let’s move ahead to the the latest 12 month comparison. It’s certainly a different story. The PC deflator is sitting right at 3%. Earlier before this podcast, you were telling me that the CPI is more like 4%.

But the implicit price deflator tends to be a little bit lower, so it’s at 3%. Production items in agriculture are right at about zero. That’s good news, but you have to remember it’s zero after a relatively large increase in ’22. And so you’re probably still looking at some pretty high break even prices for ’24.

The good news is related to fertilizer. A lot of the fertilizer prices are down 30 to 40%. Anhydrous is down even more than that. And then also we’ve seen some relief with ag chemicals. Some of the other inputs such as supplies, machinery, buildings, wages are either zero or are up slightly, but it’s certainly a different story than what we were talking about in 2022.

Brady Brewer: Definitely seen some relief on some of the ag inputs where they’re, I don’t wanna say returning to normal, I don’t think normal is is the correct term here, Michael, but definitely moderated from some of the highs we saw in 2022. With that said, you still see some categories, lagging. Wages in particular are up 5% this year. But that’s pretty normal. Wages over any industry tend to lag other increases in costs.

Michael Langemeier: Yes, that’s usually the case.

Brady Brewer: Inflation has moderated, it’s still positive, as you said the overall CPI index is still right around the 4% mark. And depending on what you’re including in that, if you’re measuring core inflation or if you’re adding in food and energy, it can be a little bit higher, lower, depending on what you’re adding into that. So that’s still above the Federal Reserve’s 2% target of inflation. So we’re still a little bit high, but it’s much better than the 6-8% we saw last year at this time.

 

[00:03:49] Interest Rates

So now let’s transition to what this means for the ag credit markets. Inflation’s moderating, but we’ve still seen some increases in the fed funds rate. In fact At this last FOMC meeting at the end of July 2023, the Federal Reserve increased the fed funds rate another 25 basis points or a quarter over percent. So right now the target fed funds rate is five and a quarter to five and a half as we head into fall of 2023.

The June FOMC meeting was one of the first FOMC meetings in over a year where they did not raise it. And that was a relief for a lot of people ’cause that saw the moderation of this historical increase in the fed funds rate. You know, the average since 1973 of the fed funds is 4.9. So if you look at it from a historical perspective, I know you and I have talked about this on previous podcasts, is that while the rate of increase that we saw in 2022 for a lot of the interest rate was unprecedented, the levels of interest rates, the level of fed funds was right around what I would call historical averages. So the historical average, over the past 40 years is 4.9, so we’re right above that.

Michael Langemeier: Yes. Like you said Brady, we increased about 5% in essentially a fairly short period of time. 18 months. That’s obviously a very large increase, but I think where we’re at today is probably more normal than staying at that sub 1%, below 1% or below. If you look at the average since 2007, it’s only 1.1%. That’s the outlier when you look at this historically. So when we start talking about projections here in a little bit, just remember that we’re probably not going back to that 1.1% anytime soon. We’re gonna have something that’s higher than that, that’s more normal if you will.

Brady Brewer: Well, so Michael, you mentioned the projections.

Michael Langemeier: Let’s just talk about these. This is from the Federal Reserve Board in their latest meeting. For 2023, they have a projection of 5.6%. Right now it’s 5.33%, so maybe one small increase later this year might be expected. And I think that’s what the press has been talking about. But then they’re thinking that the Fed funds rate will decline. And so in 2024, it’s down to 4.6%. Obviously there’s a band around this. Because they make projections by individual.

And then 2025, they’re taking it down to 3.4%. And I think if you look even longer term than that, it seems like they’re heading towards about 3%.

Brady Brewer: So again, if you look at the end of 2023. So as we go through the end of this year it looks like they’re projecting one more rate hike. You know, so they’ve moderated from increasing the Fed funds rate 50 basis points of time to here in July, as I said earlier, 25 basis points. There’s several meetings left on the calendar, but essentially they’re predicting another 25 basis pointer or a quarter percentage point increase left here in 2023. And they’re really thinking that that may be the last rate hike of the Fed funds for the foreseeable future ’cause they are predicting it to moderate by the end of 2024, and then obviously 2025.

However, as you said, the variance in those projections gets to be pretty wide. As you think about expectations of what Fed funds rate will do over the next two years. In particular, in 2025, if you look at the FOMC board’s projections of what they want it to be, there’s someone who’s a voting member of the FOMC (Federal Reserve Open Market Committee) that thinks that at the end of 2025, so not the beginning. The end of December of 2025, the Fed funds rate will still be close to 6%. And then there’s another voting member that thinks it will be below 2.5%. So that’s a pretty large range. And obviously these are based on expectations of what these individuals think will happen to inflation, whether the moderation we’ve seen will continue or if maybe it’ll slow down. We’ve heard the soft landing argument of what will happen to the overall economy. Maybe the decline in inflation will be a little bit more moderated here over the next two years.

They are also monitoring unemployment. If you read the transcript from the latest FOMC meeting, unemployment’s right at 3.6%. At this time, the Federal Reserve does not appear to be very worried about unemployment increasing from these rate hikes, but I know that is something they’re definitely moderating.

Now you mentioned the long-term Michael. It is very clear when you look at the projections of what the FOMC committee puts out for their longer term projections of the Fed funds rate. This is beyond three years, so 2026 and beyond, the range is from right under 4% for the fed funds rate, down to right around 2.5%. So, you know, for an average of right around two and three quarters to three. It is very clear that the FOMC does not want to return to the rate environment that we’ve had and enjoyed over the last 15 years. That average that you shared earlier of 1.1% average fed funds rate from 2007 to now, they are not wanting to return to that. They want a stable fed funds of over 2% in the long term.

Michael Langemeier: And that would bring it slightly above inflation, which would make sense. You’d expect that long run real fed funds rate to be be slightly positive.

Brady Brewer: Yeah. And I will use the term, Michael, here of normal, right?

Michael Langemeier: Yeah.

Brady Brewer: I think having a Fed funds rate of slightly above 2% when you have an inflation target of 2% is what I would call the Fed trying to return to normal policy. Now, as we know, and this is something before we started recording this podcast, this is if everything goes to plan. If we have another recession, another blip in the economy, these projections can go out the window real fast and maybe they will return to what we call the zero lower bound fed funds rate where it returns to essentially zero or at least the targets between zero and 0.25%. But they are giving indications that they don’t wanna return to that.

 

[00:09:44] Ag Operating Loans

Brady Brewer: So let’s talk a little bit about what this means for actually the interest rates that farmers are paying when they go to the bank. This is from the Kansas City ag Finance data books. They collect surveys from bankers all across the nation for all of the ag credit, the Federal Reserve territory. So I pulled data from just the Chicago and St. Louis Federal Reserve, which serve Indiana. And at the end of 2023, quarter one, so we don’t have quarter two data yet, so that would be up through the end of June. So this is just through the end of March of quarter one. This data lags a little bit. The average fixed short-term operating note interest rate for both the Chicago and St. Louis Federal Reserve District. It’s right around eight per 8%. We’re right shy of it. I think a year and a half ago, Michael, we were on this podcast and we were talking about where we were projecting. And you know, we thought that 8 to 10% range, if we have another quarter basis point, you know, we may get up into the low eights. But right now the operating notes are right around 8% for Chicago and St. Louis.

Michael Langemeier: A rule of thumb that I use, and this does not hold fast necessarily, but if you add 3% to the Fed funds rate you get closer to a prime rate. And if you use that particular number, let’s say we get to a 5.6% fed rate, that would put the prime rate at 8.6%.

Now that relationship hasn’t held real steady earlier this year. But if you used that relationship, you’re looking at something between 8.5 and 9 perhaps later this year.

Brady Brewer: Yep. And as I said, this data is from March. We’ve had several rate increases since then. So I fully expect when the data for the second quarter of 2023 comes in, it is in the low eights.

Michael Langemeier: Yes.

Brady Brewer: So we may get to that 9% or at least high eights.

 

[00:11:27] Farm Real Estate Loans

Brady Brewer: That’s operating note, let’s turned now to farm real estate loans. And those are a little bit lower risk in terms of lending here. The St. Louis Federal Reserve District was right around 7.8% for a fixed interest rate loan for farm real estate loans. And the Chicago Federal Reserve District was a little bit lower, at 7.1%. So we have seen some fairly substantial increases in fixed interest rates for both operating and farm real estate loans here over the past year, year and a half.

One of the things that I’ve been paying attention to, and Michael, I know we’ve talked about this before, but thinking about variable versus fixed interest rates. So I dug into the data and one thing that surprised me, so I’ll be honest here, I was not as familiar with this data. The Kansas City Fed, collects data from bankers on the lending conditions and the terms of loans that they give to farmers all across the nation. This is national data here, not any one particular Federal Reserve district, but the share of non-real estate loans. So this would be equipment loans or operating notes that are given to farmers. The share of variable interest rate loans climb to rider under 80%, so that means 80% of operating loans given to farmers here at the beginning of 2023, were on variable interest rate. Now I do want to give the caveat here, these are operating notes. Or maybe medium term interest rate loans that are 3, 5, 8 year loans, so they’re not your 20 or 30 year land loans. So when we say variable interest rate, a lot of times that’s not gonna impact these loans ’cause an operating notes due within the year. So very little chance that you even see any adjustment to the interest rate by the end of the year. A lot of these aren’t impacted too much, but maybe the intermediate loans that are five, eight years could see, you know, if they were made five years ago could have seen rate adjustments here over the past year.

This spurred some interest in me ’cause, quite frankly a little surprised that that many were on variable interest rate loans. And obviously this is not including farmland, most farmlands on fixed interest rate loans. So when you look at the difference, the spread between variable and fixed interest rate loans while historically it’s been about 25 to 50 basis points between the two. In other words, you get a 25 to 50 basis point discount for going a variable interest rate, at least initially. That’s really closed here over the past year. In fact the difference is about 10 basis points, so a 10th of a percent. So not much of a discount given to farmers if they choose that variable interest rate loan. And that’s on farm real estate loans. So the long term, it’s even lower of a gap if you look at it from an operating loan perspective, essentially there is no discount given to going variable interest rate versus fixed for an operating note.

Michael Langemeier: I’m wondering, Brady, have you studied this in the home mortgage industry? This seems to be different than what we see in the home mortgage industry.

Brady Brewer: Yeah, so it is different. You know, I can tell you A- I’ve seen the data. It’s a little bit larger of a gap. Lenders typically will give a little bit more of a discount if you go a variable interest rate. And I will also speak from personal experience. Having bought a house within the last five years and getting the quotes for variable versus fixed. The variable was much more attractive. But also knowing that there could be interest rate hikes in the near future since we were at the zero lower bound, you know, could only go up. So I locked in my rate, but it was about a 50 to 75 basis point difference between the interest rates of variable versus fixed. So yeah, I would say the smaller difference is well, I don’t wanna say unique to agriculture. It’s definitely different than what we see in, say, the general housing market.

Now one of the things I was also interested in, so we’ve seen these large interest rate increases. I was a little bit curious to know what this has done to demand for loans. So the loan volumes that we’ve seen. For those of you that don’t know, one of my appointments here at Purdue is I work with the agricultural bankers here in Indiana doing educational trainings. And when I meet with them, especially here in 2023, I’ve gotten a lot of feedback this year, especially that liquidity is higher in agriculture, there’s working capital out there. And that coupled with the increased cost of money, so the increase in interest rate, a lot of farmers have chosen not to do operating notes to use their liquidity reserves. And this has resulted in a lower demand for loans. And sure enough, this appears in the Kansas City data. The loan volume is down relative to a year ago. Not substantially, but you do see it in the data. Where you do see a pretty big difference in the data is they also track the number and average loan size that ag bankers are giving to farmers. And while the loan size is down from a year ago we have seen a pretty substantial decrease in the number of loans that bankers are reporting making to the agricultural sector. So I think this is driving some of that farmer behavior of being less willing to utilize the bank if there is liquidity available.

Michael Langemeier: It’ll be interesting to see how this plays out here the next few quarters as we get more data from the Federal Reserve Bank of Kansas City and other Federal Reserve banks. But also as liquidity, you know, slips a little bit. I mean, certainly 2023 looks like a lower net farm income here. And just looking at ’24, it looks like more of the same. And so this is gonna be interesting to follow. And so next time we do a podcast, we’ll have to take a look at this again.

Brady Brewer: Yep. I definitely think we may see different numbers if we’re doing this podcast, even just six months in the future.

Michael Langemeier: Yes.

 

[00:17:01] Producer Perspective

Brady Brewer: I think this could look a little bit different. So Michael, I want to turn now, you and Dr. Mintert in the Center for Commercial Agriculture do the Ag Economy Barometer. And you guys have been adding questions to the barometer about their thoughts on the ag credit markets and then where interest rates are going. So we’ve talked a lot about where the FOMC, the people making the policy see interest rates going. But let’s turn to what the farmer’s expectations are around the ag credit market. What do farmers think are gonna be happening here?

Michael Langemeier: They’re a little bit more pessimistic than what we’ve been discussing here so far. When we surveyed people in July, 32% of the respondents indicated that they thought prime interest rate would be zero to 1% higher. That would be consistent what we’re talking about. However, one third of the group thought the prime interest rate would be one to 2% higher. That would take us in that nine to 9.5 to 10.5% you know, prime interest rate. And so a little bit more pessimistic than what we’ve been talking about.

So perhaps they’re not quite as convinced that inflation is under control. Interestingly ,18% thought that we were gonna see lower prime interest rate in the next 12 months. I don’t know what crystal ball they’re looking at, but maybe that’s wishful thinking.

Brady Brewer: It is definitely possible. I mean, especially if you compare it to the, the data we discussed earlier, a fair amount of the voting members of the FOMC Open Market Committee do expect a lower interest rate at the end of 2024. So maybe if those decreases in the Fed funds rate happened at the beginning of 2024, so just six months from now. It could be possible, but

Michael Langemeier: And perhaps they’re a bit more negative on the economy. Obviously if the economy doesn’t look very good in early ’24, they’re gonna change their policy.

Brady Brewer: Yep. Yeah, so there could be a variety of factors. I do think it’s interesting, Michael, essentially a third are really pessimistic on interest rates, you know, so 33% think that we’re gonna go to that nine and a half to 10 point half percent range of interest rates. A third are pretty moderated. Think it’s gonna stay the same or maybe just marginal increases to the fed funds rate. And then a third are pretty optimistic that we’ll see some lowering interest rates. So it’s pretty divided in sentiment out there amongst the farmers.

Michael Langemeier: That’s definitely the case.

Brady Brewer: So that’s their expectations for the interest rate. But looking ahead, how does this translate to concerns at the farm level?

Michael Langemeier: Yeah, I wanted to talk a little bit about how this is impacting both operating and also non-operating loans. So looking ahead a little bit and one of the ways to do that is look at the biggest concerns for their farming operation. We do this question every month, and for the last 12 months, probably 12 to 15 months, higher input cost has been the number one concern. That remains the number one concern, input costs are moderating a little bit, but they’re still relatively high compared to what they were in 2021, for example.

Right now ranking second above lower crop and livestock prices, which we’re certainly seeing especially for crop prices, is rising interest rates. And so obviously this is on a farmer’s radar. As we’ve talked about before production agriculture is a very capital intensive business. There’s a lot of money tied up in assets, and so they know how this works. It’s tougher to buy assets with higher interest rates, but also we know that if interest rates are higher, that tends put downward pressure on asset values, particularly land. So it’s certainly on their radar.

Also it’s on their radar in terms of buying machinery. We ask people what’s the primary reason that now is a bad time to make large investments in machinery and about half think this is not a good time to buy machinery. The question is why? You know, they have liquidity. A lot of farmers have liquidity, so that’s not necessarily the concern. Rising interest rates is the number one thing that they talk about when they think this is a bad time to buy machinery, as well as relatively high prices for farm machinery and new construction.

Finally, if you go to factors impacting farmland values, unlike the Purdue (Farmland Values & Cash Rental Rates) survey, we don’t necessarily ask them whether these factors are negative or positive. These surveys are fairly simple because they’re phone surveys and so we simply say which of the following factors have the most influence on farmland values. That could be positive, could be negative. And they have interest rates as the number one item there. And of course, interest rates rising and interest rates is negative to farmland values. And so that they certainly understand what’s at stake here.

Interestingly, inflation’s right up there with alternative investments in terms of being as important factor. What I mean by alternative investments is interest in people outside of production agriculture in buying farmland. That’s talked a lot about in the press and elsewhere. But inflation’s actually number two on this list. We know that those inflation and interest rates work together a little bit. So certainly interest rates are also on their minds when you’re looking at farmland values.

And the main point I wanted to make there is when we talk about increasing interest rates, sometimes it’s easy to focus on what’s happening to operating interest rate. But interest rates are also really important to machinery purchases and farmland purchases and values, because of the capital intensive nature of production agriculture. This is true of other industries in the U.S. like manufacturing, construction. There’s a lot of industries like this, but production agriculture relies very heavily on machinery, buildings, grain bins and of course farmland.

 

[00:22:03] Conclusion

Brady Brewer: So in summary, the Federal Reserve just increased the Fed funds rate by another 25 basis points for a target range between five and a quarter and five and a half. The current ag interest rates, whether it be for operating or farmland is about 8% for operating and then somewhere between seven and 8% for farmland.

The Fed is expected to raise interest rates another 25 basis points through the end of this year. Obviously, that is not set in stone and could be more or less depending on what we see on the inflation numbers and unemployment numbers that we see in the overall general economy. So expect interest rates to continue to increase at a moderate rate.

Farmers’ expectations are a little bit divided on that. There’s a third of farmers that think that the interest rates are gonna increase a lot more than what the Federal Reserve is. A third are pretty much in line with the Federal Reserve forecast. And then another third of farmers are fairly optimistic that we’ve seen the last rate hike, and it could actually start decreasing here at the end of 2023 or beginning of 2024.

Interest rates are top of mind for farmers as they cite interest rates as a major concern when buying new machinery and a major contributor to the impact of farmland values.

For more economic information, visit us at the Purdue Center for Commercial Agriculture’s website, purdue.edu/commercialag. You can also visit us on Twitter at PUCommercialAg. On behalf of the Center for Commercial Agriculture, I’m Brady Brewer and we thank you for listening.