The Federal Reserve Bank, known as the Fed, has opted for several rate hikes over the past year to combat rising inflation. Inflation can be caused by various factors. However, it is generally the result of too much demand and insufficient supply, leading to high prices. Many Americans received excess funding during the pandemic, and with supply chain disruptions, items were in high demand and unavailable, and the cost of these items increased.
Raising interest rates is one option the Fed is pursuing to keep inflation in check, reducing the economy’s money supply. In general, the money supply is the total amount of money in circulation throughout the economy. The Federal Reserve can control the money supply through quantitative easing, a Treasury-backed process of buying and selling assets. During the pandemic, the Fed chose to buy assets so banks could lend to individuals and businesses. The Federal Reserve is now trying to sell these assets, reduce the money supply and keep inflation under control.
Commodity price impact
Research shows that changes in interest rates and the money supply affect commodity prices. The Fed’s policy of lowering interest rates and building a larger money supply during the pandemic may be correlated with higher commodity prices. Thus, the Fed’s new policy of raising interest rates and shrinking the money supply could push commodity prices down.
High inflation and rising interest rates can undermine the liquidity of agricultural businesses. Liquidity is the farm’s ability to meet its financial obligations when they come due. Farmers may have been paying attention to rising commodity prices and the resulting income, but they may not be aware that rising inflation is causing input costs to rise rapidly. If commodity prices start to fall, costs may remain elevated, slowing downward revisions. Profit margins could decline and even become negative, which could increase the demand for more farm debt in the future.
Current Farm Debt
The Federal Reserve chose to cut interest rates following the “Great Recession” by cutting the Federal Funds Rate, the short-term rate that banks charge each other, and holding it near zero for several years. These low interest rates made it possible for farmers to borrow cheaply, leading many to borrow cheaply. A summer report issued by the Kansas City Federal Reserve Bank reported a significant increase in agricultural real estate debt in the second quarter of 2022. As Chart 1 below shows, changes in agricultural income (blue line) over the past decade were negatively correlated with changes in agricultural bank loan balances.
Many farmers have opted for greater liquidity during the pandemic, taking advantage of higher commodity prices and government program payments to pay off outstanding accounts payable, lines of credit, and loan balances. However, lower input costs creep up on the farmer, and he may use these short-term debt again in 2022 and 2023.
Rising interest rates lead to increased risk
Rising interest rates have a direct impact on farmers who owe money. For example, a lender’s line of credit, which fluctuates throughout the year, may have increased by 3% since March 2022.
Now that interest rates have risen, there are some considerations to mitigate risk.
- Complete a financial analysis of your agricultural business to check your repayment capacity and liquidity ratios.
- Please consult your lender regarding these ratios and loan debt structure.
- Determine if the interest rate on the loan is fixed or variable. Floating rate loans have been affected by the Fed’s rate hike policy.
- Create a cash flow forecast to see how your profit margins will be affected by additional rate hikes. If your margin decreases, consider restructuring your loan at a fixed rate.
- Complete a sensitivity analysis to determine how changes in various commodity prices and input costs and interest rates affect cash flow. Consider marketing options to lock in product prices. Check for costs that may have increased due to inflation.
Farmers may be better positioned to deal with falling commodity prices. But not all farms cope well with rising interest rates. Farmers who plan to take out new loans, renew operating loans, or have variable rate debt that could be adjusted higher as interest rates rise are more likely to face potential refinancing or debt restructuring. should be discussed with the lender.
Rising interest rates can hurt profitability, so farmers should work with their lenders to check their financial situation. Agricultural financing can be an important tool for continuing production, expanding operations, and experimenting with different ventures. Try to build strong relationships with lenders. Rising interest rates and input costs could be part of the cash flow challenge for farms over the next year.
Katie L. Wantoch is a Farm Management Outreach Specialist/Professor of Practice at the Agriculture Institute, UW-Madison Department of Extension.