Matt Erickson, agriculture economic and policy advisor for Farm Credit Services of America, explains the specific market indicators that guide the Fed’s decision process, possible future cuts, and what this means for producers.
Hello, I'm Matt Erickson, agricultural economic and policy advisor for Farm Credit Services of America. I'd like to recap with you the Federal Reserve September meeting and what this actually means for producers.
Last week, the Federal Reserve enacted its first rate cut since 2020. Lowering its borrowing rate by 50 basis points to a target range between 4.75% and 5%. This move by the Federal Reserve was a significant step aimed at supporting economic growth. The decision came as inflation continues to soften. The Federal Reserve's preferred measure of inflation, the personal consumption expenditures price index has declined from 2.9% at the beginning of the year down to 2.6% excluding food and energy.
The Fed's goal remains 2% inflation. However, it's important to note that services inflation remain sticky, indicating persistent underlying pressures in certain sectors in the U.S. economy.
Service sector categories such as motor vehicle insurance and the food services such as restaurants continue to remain sticky as labor costs remain elevated.
The pullback in shelter inflation, such as rents, has also been slower than expected.
The Fed's decision comes at a time when U.S. economic growth looks to be solid. A healthy gross domestic product or GDP for the United States is generally considered to be an annual growth rate between 2 and 3%. And the second quarter, GDP was revised from 2.8% to 3%. The Atlanta Fed is also forecasting near 3% growth in the third quarter of 2024.
The positive outlook is based on continued strength and consumer spending. As retail sales continue to show resilience. The robust consumer spending is a key driver of this economic growth, indicating that despite various challenges, the U.S. economy is maintaining its momentum.
The Federal Reserve's goal is to achieve a situation where price stability can be restored in the marketplace without a significant increase in unemployment. Currently, the unemployment rate remains low at 4.2%, but it has been trending upwards since the first quarter of 2024.
The U.S. labor market is still strong. Over the past 50 years, the unemployment rate has averaged 6.2% while unemployment rates during non-recessionary periods since 1974 have averaged 6%.
However, there are signs that the U.S. labor market is slowing down. Over the past six months, and even over the past year, layoffs have increased while hiring and quits have slowed significantly. Job openings have also declined over the past six months and year. In fact, while job openings per unemployed person remain above historical averages, there are currently just over one job opening per unemployed person, the lowest since May of 2021.
This indicates a tightening labor market, which could pose challenges for both job seekers and employers. The Federal Reserve will need to carefully balance its policies to maintain economic stability without exacerbating unemployment.
Last week, the Federal Reserve also released a quarterly summary of economic projections that included an expectation for around 2% real GDP in 2024, inflationary pressures until 2026, and an unemployment rate below 4.5%.
The Fed also provided insight into their future rate decisions through a dot plot that records each Fed official's projection for the central bank's key short-term interest rate. The Fed signal plans to reduce borrowing costs even more in 2024.
Fed officials indicated in a target range of 4.25% to 4.5% for the benchmark federal funds rate by the end of this year. Indicating two quarter point rate cuts or one-half point cut. For 2025, they expect to cut borrowing costs at an equivalent of a hundred basis points from their expectations from 2024, bringing the key benchmark interest rate to 3.25% to 3.5%. And longer term, the median federal funds rate is projected to be 2.9%.
These projections provide a roadmap for the Fed's approach to managing economic growth and inflation in the coming years.
So how do the Fed's projections align with market expectations?
The CME Fed Watch tool uses prices of Fed funds, futures contracts on the CME to project the real time probability of federal funds rate changes.
Navigating interest rate changes is important for any farm or business. It could also be valuable tool for those managing risk or hedging against changes in fed monetary policy.
From the chart, the dotted red line shows the upper limit of the federal funds rate that represents the highest probability of where the CME Fed Watch tool projects the federal funds rate at future Federal Reserve meetings, starting with the fed's November 2024 meeting, and going out to October of 2025. The green dots indicate the median federal funds rate projection for '24 and '25 from the Fed's September summary of economic projections. Currently, market expectations and Federal Reserve projections on interest rates are slightly misaligned. As shown from the blue circle at an upper limit of 4.25%, the market projects an additional 75 basis point reduction in 2024, whereas the Fed projects an additional 50 basis point reduction. For 2025, the market projects slightly further reductions than the Fed's median projection of 3.4%.
While the Federal Reserve has signaled intentions to cut interest rates, the exact magnitude of cuts remains uncertain, given future inflation and labor expectations. As a result, the Fed will be data dependent ahead of each meeting.
So why is it important for market expectations to be aligned with the Federal Reserve?
For several reasons, one is market stability. When market expectations are aligned with the Fed's projections, it helps maintain stability in financial markets. Unexpected changes in interest rates can lead to market volatility affecting stocks and bonds. Two is economic planning; businesses, farms and consumers rely on interest rate projections for investment purposes. Spending, as well as even savings misalignment, can lead to uncertainty and poor financial decisions affecting economic growth and the stability of a farmer business. And three is credibility and trust. When the Fed is transparent, it builds trust among the market investors, businesses as well as consumers, which is important for the overall economic environment.
When the Federal Reserve cuts its benchmark interest rate, it typically leads to a decrease in the prime bank rate. Since July of 2023, the bank prime loan rate has held steady at around 8.5%, and as of last week fell to 8%. Historically, the 30-year spread between the federal funds rate and prime has been roughly 307 basis points. This historical spread can be utilized for planning, marketing budgets, as well as stress testing those scenarios from those marketing budgets for 2025.
As shown in the chart, the outlook from the CME Fed Watch tool shows an environment over the next year where interest rates are projected lower. In fact, potentially below the time series average since 1955. By October of 2025, the CME Fed Watch tool projects the federal funds rate at a range between 2.75% and 3%. If the 30-year spread between the Fed funds rate and prime is realized, the prime bank rate would be approximately 6%.
While lower commodity prices and higher input costs have created a high-cost low margin economic environment, this would provide some relief for producers as the cost of borrowing to finance operations decreases. It also provides producers with opportunities to manage the debt, the debt that they have incurred over the past few years at high interest rates.
So what can producers do now as they plan for 2025?
First, work with your Farm Credit financial officer to stay current on the overall interest rate environment, as well as understand what it means for your operation. Economic conditions can change quickly in the current environment based on market sentiment, policy changes, as well as updated market data.
Interest rates can vary from producer to producer, but so can options for managing interest rate costs. With a lower commodity price environment, finding ways to manage and cut costs while building working capital and gaining efficiencies will be critical to bottom lines for 2025. There could be opportunities for refinancing and lowering interest payments in the future.
Thank you all for joining me as I recap the Fed's September meeting, what this means for the U.S. economy and what this means for agricultural producers.
