Rising input and labor costs have already created significant concerns for agricultural producers today. One of the major causes of rising costs is the high inflation rate which now stands at the highest level in the last four decades.
Among some of the options available for the Federal Reserve System (the Fed) for lowering the inflation rate, adjusting the federal funds rate tends to be one of the first options to consider. Indeed, the Federal Open Market Committee (FOMC), a committee within the Fed, raised the federal funds rate multiple times this year. These federal funds rate hikes already had a significant impact on consumer loan rates, including agricultural loan rates. How does this work, and what should we expect for the rest of 2022 and 2023?
First, the federal funds rate is the interest rate at which depository institutions trade federal funds (balances held at the Fed) overnight. The federal funds rate is important because it is the central interest rate in the U.S. financial market. It influences short- and long-term interest rates such as mortgages, loans, and savings. While it is certainly possible that these consumer loan rates may not react to the changes in the federal funds rate, they tend to move in the same direction. This means that when there is a federal funds rate hike, consumer loan interests are likely to increase.
At the beginning of 2022, the effective federal funds rate was at 0.08%, which was significantly lower than the 10-year average of 0.72%. The Fed has maintained a low level of the federal funds rate since the COVID-19 pandemic to ensure enough financial capital is circulating in the economy. Yet, prolonged low federal funds rate and interest rates contributed to the rapid increase in the inflation rate, and the Fed is now rapidly increasing the federal funds rate. From 0.08% in January, the effective federal funds rate now stands at 3.83%.
How have farm loan interest rates reacted to the federal funds rate hikes? USDA’s Farm Service Agency (FSA) provides farm loan interest rates which are updated monthly, and we can observe how farm loan interest rates have changed in the past few months. Operating loan interest rates, ownership loan interest rates, and emergency loan interest rates have all spiked in the past twelve months. One year ago, interest rates for operating, ownership, and emergency loans were at 1.75%, 2.875%, and 2.75%, respectively. Interest rates have more than doubled since then, reaching 4.5%, 4.375%, and 3.75% on November 2022. While the magnitudes have varied, we can see that the farm loan interest rates have moved in the same direction as the federal funds rate. Farm loan interest rates issued from commercial banks are not available on a monthly basis, but these rates also tend to move in the same direction.
What should we expect for farm loan interest rates for the rest of the year and 2023? The consensus is that the Fed will increase the federal funds rate significantly for the rest of 2022 and 2023. The current forecast is that the FOMC will increase the federal funds rate to 4.4% by the end of this year and to 4.6% by the end of 2023. This will inevitably result in continued increases in farm loan interest rates as well. This means that cost of financing will increase for the next few quarters, especially for new loans and existing floating-rate loans that do not have fixed terms. We expect the federal funds rate to lower to 3.9% and 2.9% for 2024 and 2025, making it doubtful that we will return to the favorable loan terms from 2020 or 2021.
Author: Kevin Kim