The Federal Reserve Bank, known to many as the Fed, has chosen to raise interest rates several times over the past year to combat rising inflation. Inflation can be caused by different factors; however, it is usually the result of too much demand and too little supply, leading to high prices. Many Americans have received excess funds during the pandemic, and along with supply chain disruptions, this has resulted in increased demand for items, an inability to obtain those items, and an increase in the cost of those items.
Raising interest rates is an option that the Fed pursues to calm inflation, thereby reducing the money supply in the economy. Generally, money supply is the total amount of monetary circulation in the economy. The Fed can control the money supply through quantitative easing, the process of buying and selling assets backed by the Treasury Department. During the pandemic, the Fed chose to buy assets, allowing banks to lend to individuals or businesses. The Fed is now selling those assets, reducing the money supply and trying to reduce inflation.
Impact on commodity prices
Research shows that changes in interest rates and the money supply influence commodity prices. The Fed’s policy of cutting interest rates and building more money supply during the pandemic could be correlated with higher commodity prices. Thus, the Fed’s new policies aimed at raising interest rates and reducing the money supply could lower commodity prices.
High inflation and rising interest rates will likely erode a farm’s cash flow, or farm’s ability to meet its financial obligations as they come due. While a farmer may have paid attention to rising commodity prices and resulting incomes, he may not have noticed the rapid increase in input costs due to rising l ‘inflation. If commodity prices begin to fall, costs could remain high and take time to adjust downward. Profit margins can be reduced and even turn negative, leading to future demand for increased farm debt.
Current farm debt
The Fed chose to cut interest rates after the “Great Recession,” lowering the federal funds rate, the short-term interest rate that banks charge themselves, and keeping it close to zero for several years. . These low interest rates resulted in cheap borrowing for farmers and encouraged many to take on cheap debt. Summer reports from the Federal Reserve Bank of Kansas City showed strong growth in farm real estate debt, pushing up farm loan balances in the second quarter of 2022.3 Outstanding Farm Debt grew about 5% from a year earlier, the fastest pace in almost six years. . As shown in Chart 1 below, the last ten years have seen changes in farm income (blue line) that have been negatively correlated with changes in farm bank loan balances.4 As farm income decreased, more farmers sought loans from agricultural banks.
Many farmers have chosen to boost their cash flow during the pandemic, using high commodity prices and government program payments to pay down accounts payable, lines of credit and loan balances. However, falling input costs may sneak up on farmers and drive the reliance on these short-term debt securities again in 2022 and 2023.
Rising interest rates lead to increased risks
Rising interest rates will have a direct impact on farmers who borrow money. For example, a line of credit with a lender that is expected to fluctuate throughout the year may have increased by 3% since March 2022.
Here are some considerations for reducing your risk now that interest rates have risen.
- Perform a financial analysis of your farming business to examine repayment capacity and liquidity ratios.
- Consult with your lender about these ratios and the debt structure of your loans.
- Determine if your loans have fixed or variable interest rates. Variable interest rate loans were affected by the Fed’s rate hike policy.
- Develop a cash flow projection to see how your profit margins could be affected by further rate hikes. If margins are tight, consider restructuring your loans to a fixed interest rate.
- Perform sensitivity analysis to determine how different commodity prices and input costs as well as changes in interest rates will affect your cash flow. Consider marketing options to lock in commodity prices. Review expenses that may have increased due to inflation.
Farmers may be well positioned to weather falling commodity prices. Yet not all farms are well positioned to weather rising interest rates. Farmers considering taking out new loans, renewing operating loans, or who have variable interest rate debt that may adjust upward as interest rates rise should consult their lender at subject to a possible refinancing or restructuring of their debt.
Rising interest rates can hurt profitability, so a farmer should work with their lender to review their financial situation. Agricultural finance can be a crucial tool for continuing production, expanding operations or trying out different businesses. Make sure you have a solid relationship with your lender. Rising interest rates and rising input costs can be part of a farm’s cash flow problems in the coming year.
Katie L. Wantoch is Farm Management Outreach Specialist/Professor of Practice at UW-Madison Division of Extension, Agriculture Institute