From The Fields: Rising Interest Rates and Their Effect on Production Agriculture
By Lance Lansing, Wisconsin Bank & Trust
While many of us were alive when interest rates reached the record high of 20% in March of 1980, not many of us were in lending at that time. According to bankrate.com, the inflation rate at the time was 14.6% and Fed used their main tool and increased interest rates to combat inflation. As a result, the U.S. central bank manufactured a recession to bring prices back down. Although I have never claimed to be an economist (or played one on TV), it does not take a Harvard grad to see that the Fed is once again using its main tool to combat inflation. The current Fed, instead of wielding a sledgehammer on rates, is much more subtle by slowly and gradually moving rates in one direction. However, desperate times…etcetera.
The Fed has chosen to raise interest rates six times over the past year with four straight three quarter point increases pushing borrowing costs to a new high since 2008. The March 2022 hike of a quarter point was the first hike since 2018. The Fed has chosen to raise interest rates with the objective of reducing the total amount of money circulating through the economy, called the money supply. The Fed also tries to control the money supply through quantitative easing, which is the process of buying and selling Treasury Department backed assets. Both tools are used by the Fed to try to reduce inflation. Inflation can be caused by many factors. It is generally the result of too much demand and insufficient supply, leading to high prices. Many people received excess funds during the pandemic and along with supply chain disruptions, this has resulted in rising demand for items, an inability to get those items and an increase in the cost for those items.
A Fed manufactured recession will affect us all in many ways personally and professionally. High inflation and rising interest rates will likely erode a farm business’ liquidity. While our producers have been paying attention to the increase in commodity prices and resulting revenue, they have also noticed the quickly rising input costs due to increased inflation. Should commodity prices start to decline, costs may remain elevated and be slow to go down. Profit margins will be compressed, and some may even become negative. The Ag economy will see new risks with the rising interest rates and input costs. The direct impact on farmers that are borrowing money will be significant. For example, a line of credit that has risen 3.75% from 4.75% to 8.5% since March of 2022 with an average balance of $1,000,000, will require a monthly interest payment of $7,083 vs. $3958, adding an additional $37,500 per year interest expense to their cash flow. This will, of course, impact repayment capacity, liquidity, and depending on the operation, increase cost of production to a level that will compress margins and seriously impact their operation’s profitability.
Many operations chose to increase their liquidity during the pandemic through higher commodity prices and government program payments to pay down dept. However, rising input costs and possible tax liability will increase demand for short-term borrowing. With the increased demand of short-term loans comes the risk of increased variable rates. If margins compress, more operations will seek out loans to compensate for the short falls.
Another risk from higher interest rates is the impact on expansion. When a neighbor’s farm comes up for sale, the cost per acre of owning that land has jumped significantly. A loan early in 2022, with a fixed rate at 4.25% over a 20-year amortization would now hold an interest rate of 8%. Most producers would be tempted to jump at an opportunity to buy 100 acres of adjacent land for $10,000/acre. Since most operations are asset rich and cash poor, the producer in this example will opt to finance 100% of the purchase. The total cost of $1,000,000 for 100 acres, would equate to an annual cost per acre of $747 at 4.25% vs. $1,012 at 8%. This $265 cost per acre increase would impact repayment capacity and margin. The impact of record high land values and increase in interest rates may result in producers passing on expansion opportunities and focusing on deleveraging and positioning themselves for a change in the economy.
Producers and lenders will be affected by the rate increases in several ways. The profit margins for both could be adversely affected as well as the number of opportunities for new loans and growth. Navigating this time will depend on how much higher the rates will increase and for how long before a hiccup in the economy brings them back down.
Lance Lansing is vice president of commercial and ag loans with Wisconsin Bank and Trust in Monroe. Lansing also currently serves on the WBA Agricultural Bankers Section Board of Directors.