Why Fed policy matters to farmers
Federal Reserve (Fed) pronouncements jolt stock and bond markets, just as much as USDA’s crop reports can send commodity prices spinning. But with exports, inflation, interest rates and credit availability at stake, it’s worth asking how a shift in Fed policy matters to U.S. agriculture now.
The most obvious is the Fed sets monetary policy. It is also “independent” of the federal government. It derives its authority from Congress, but its monetary policies do not have to be approved by the president or anyone in the executive or legislative branches of government.
Is that self-reliance good or bad? It depends on who you talk to or listen to. The independence from the political process is good, because the Fed can act quickly and isn’t paralyzed by partisanship. It’s bad because it is so powerful and yet doesn’t really have any oversight except for the combined wisdom of the Federal Reserve Board of Governors, the chairman of which is often called the most powerful man in the world. Just recall three of the best known: Ben Bernanke, Alan Greenspan and Paul Volker. A single statement from the chairman can move financial markets around the world.
In June, Bernanke announced the possible ending of the Fed’s quantitative easing “asset purchase” program by late 2013 or early next year. He didn’t really say anything he hadn’t been indicating all along, he just said it in words the people could understand. This discussion and related arguments, pro and con could go on forever, but let’s look at some specific impacts on farmers.
Ripple effects from rates
The first is the impact on interest rates. If the Fed keeps interest rates low, as it has for the last few years, the cost of borrowing is cheap and consumers and businesses are encouraged to borrow.
Another important element is impact on trade.
Almost every income boom period in agriculture has been tied to strong exports. Low interest rates (specifically “relative” real interest rates, which are nominal rate less the inflation rate) also lower the value of the dollar, which encourages exports by making our products cheaper for foreign buyers. A low value of the dollar also makes imports more expensive for us because it takes more dollars to buy things we require from foreign suppliers. Imported oil and fertilizer are two good examples.
Lower interest rates on U.S. Treasuries, CDs, etc., have also made agricultural assets like land more attractive than stocks or bonds.
For example, a “capitalization” rate (known as a rough estimate of borrowing cost) of 4 percent and a return to land (rent) of $400 an acre would justify a value of $10,000 an acre for Midwest farmland. If interest rates were to rise to a 6 percent cap rate, and the return to land were to fall to $300 an acre due to a higher dollar exchange rate, lower exports and increased borrowing costs, the capitalized income value would justify $5,000 an acre.
The real effect of interest rates on the general economy is that they tend to be used to encourage job growth and control inflation. Volker used tight money and high interest rates to slow inflation in the late ’70s and early ’80s.
In terms of influencing job growth, it’s a little like pushing a noodle. A lot of the slow recovery since 2008 is the uncertainty about additional regulations and future
expectations. It’s a lot easier for the Fed to slow inflationary pressure by increasing the cost of money, but it’s a fine line to keep from triggering a recession.
Spending cuts negated
Right now, one of the big impacts is on the cost of government borrowing. By keeping interest rates low, the growing federal debt has been financed and refinanced at extremely low rates.
All of the things Congress is doing through fiscal policy to cut expenses have been drops in the bucket. For example, the special bipartisan committee a couple of years ago couldn’t even come to a real agreement of how to cut $3 trillion federal spending over the next 10 years, or $300 billion per year. At a $16 trillion federal debt, a 1 percent increase in interest rates would increase the interest cost by $160 billion per year; a 2 percent hike would increase the interest cost by $320 billion per year, which would totally wipe out the proposed spending cuts.
Now that the federal debt exceeds the U.S. gross domestic product (GDP), even if the federal debt doesn’t grow, it represents a major overhang in the economy. There’s a major economic growth rate risk to increasing rates, but lack of action also represents a major inflation risk if the economy starts to pick up significantly.
Since the federal government can’t just pay all of its debt and has to keep refinancing it, there’s a risk that the private sector could be “crowded out” as the government competes for funds in the future.
How will it end?
The main issues on how high rates would go will depend primarily on two things. First, will foreign investors continue buying as large a share of U.S. Treasuries as they currently are (roughly 40 percent)? Second, will a new economic driver push up GDP?
Things need not end as badly as the gun-shy markets indicate. Currently, the most likely growth spurt for GDP is the increase in domestic energy production of both oil and natural gas. These discoveries will raise GDP, potentially making the U.S energy independent in 10 years, and increase the domestic production of nitrogen fertilizer, which would cut the need for imports and help keep production costs from rising as fast as they otherwise might.
The growth in GDP would also raise tax revenues, which would slow the growth of the federal debt. The potential is even greater if public vehicles, commercial vehicles (trucks and trains) and electric power generation were to switch to natural gas. It would grow even faster if we could increase the exports of liquid natural gas because of the natural gas price differential between the U.S. and most of the world.
Farmers over 50 still remember how Federal Reserve policy crushed the agricultural economy in the 1980s, making it a victim of inflation controls. Farm exports, farm income and ag real estate collapsed. The latest era of cheap credit may be ending, but monetary policy may not repeat such severe consequences this time around. — Danny Klinefelter, DTN Farm Business Adviser
Klinefelter is a professor and extension economist with Texas AgriLIFE Extension and Texas A&M University. He also directs The Executive Program for Agricultural Producers (TEPAP), a management short-course for farm producers held each January, and its alumni association, AAPEX