Shifting Economic Sands Lead to Higher Costs at the Farm Gate

Situation

The Federal Reserve pushed interest rates slightly higher in March to levels last seen in 2007. However, the market expectations for the Federal Funds (Fed Funds) rate have quickly shifted lower in opposition to forward guidance from Federal Reserve officials. The sharp change in expectations and difference between market and Federal Reserve messaging have increased the cost of buying optionality.

Outlook

I expect the cost of optionality to remain elevated in Q2 2023. The Federal Open Market Committee (FOMC) is scheduled to meet again the first week of May and will remain focused on inflation dynamics.

Background

At the beginning of March, many analysts were targeting a 50-basis-point hike in the Fed Funds rate at the March FOMC meeting, and a terminal, or high point, Fed Funds rate a little above 5.50% with some analyst discussing a rate as high as 6.00%. Some unexpected struggles in the financial sector took much of the punch out of these expectations.

Ultimately, the FOMC increased the Fed Funds rate by 25 basis points, while the midpoint of the Dot-Plot expectations remained unchanged from December at 5.10% for 2023. Federal Reserve officials were quick to offer forward guidance that the midpoint projection had not changed, and that the Federal Funds rate may need to remain “higher for longer” to keep inflation headed towards the FOMC target levels of around 2% in the long run. Despite this forward guidance, the market odds that the FOMC will cut rates in the second half of 2023 have increased.

Looking Forward

The FOMC is likely to continue leaning heavily on data that supports their dual mandate of maximum employment and price stability, at least in the near term. As U.S. unemployment numbers remain low, though likely to tick higher, the main pressure point will continue to be inflation. 

Recent inflation numbers have shown signs of easing, but they remain outside of the FOMC’s target level. The FOMC will also heavily monitor the health of the financial sector, as financial stability remains the primary role of the Federal Reserve. It remains unlikely that the Federal Reserve will embark on significant rate cuts at the upcoming meeting, barring a very large negative shock to the economy.

At the farm gate, the impact of these shifting sands has been twofold. First, loan products on a variable rate continued to climb higher in the first quarter of 2023. Current messaging from the FOMC suggests that variable-rate loan products may remain elevated for the coming quarter. According to data from the Federal Reserve Bank of Kansas City, more than 75% of non-real estate loans originated in 2022 carried a variable rate, which will likely correspond to higher cost of borrowing for many farmers in the first half of 2023, relative to 2022.

Second, costs have increased sharply for producers looking to take on new debt with the option to prepay, reprice or make other adjustments to the loan. The increase in the cost of optionality has been driven by the significant difference between the forward guidance from the FOMC and market expectations, along with other factors such as volatility in the financial sector, debt ceiling debates and the ongoing inverted yield curve, among others.

Until the market gains more clarity, it is likely that the cost of owning and purchasing optionality will remain elevated. Therefore, borrowers looking to take on additional debt should continue to communicate with their lender to understand their options and available products.