The U.S. economy remains strong by many economic measures. Two-plus years of low unemployment continue to drive year-over-year wage growth, while gains in the stock market have increased the net worth of U.S. households. Consumers, in turn, are spending.
But that same good news for workers and households is bad news for a Federal Reserve intent on taming inflation. The March Core Consumer Price Index (CPI), excluding food and energy, was up 3.8%, well above the Fed’s 2% target. While markets still anticipate interest rate cuts in 2024, the Fed’s next steps remain unclear. It kept interest rates between 5.25% to 5.5% in March.
Agricultural producers need to plan for the possibility that interest rates will remain higher longer. Financial efficiency will be critical in the year ahead and we have some ratios to help you focus on the right areas of your business.
Interest Rate Drivers
The U.S. unemployment rate is at 3.8%, with 1.36 job openings for every unemployed person. Unemployment has now been under 4% for the longest stretch since 1967, following the Vietnam War and leading up to the 1970 recession.
The tight labor market has led to year-over-year wage growth of 4.1%, well above the average wage growth of 2.5% prior to the COVID-19 pandemic.
The resulting inflation is a challenge for both the Federal Reserve and U.S. consumers. The March CPI for all items was 3.5%, up from 3.2% in February. The U.S. has now reported 28 consecutive months of core services above the Fed’s 2% target, as shown in Figure 1.
More concerning for the Fed is the sticky-price CPI, so-called because prices on included goods and services change less frequently. This CPI, which excludes food, energy, and shelter, stands at more than 3.1% year-over-year, the highest since July 2023. The sticky-price CPI is thought to incorporate expectations about future inflation to a greater degree than prices that change on a more frequent basis.
Stress Signs for U.S. Consumer
The U.S. consumer has proven resilient in the face of inflation and higher interest rates, largely due to wage growth, long-term debt locked at record low interest rates, government stimuli during the pandemic and student loan forgiveness. However, stress signs are emerging, including in the areas of disposable income and debt.
In 2023, monthly year-over-year growth in per capita, inflation-adjusted disposable incomes averaged a robust 3.7%. For context, the pre-pandemic average was 1.6%.
While still positive year over year, wage growth is weaker. Per capita real disposable income in February 2024 was 1.1% higher than in February 2023, but 0.1% lower than in January 2024. The pace of wage growth has slowly subsided since March 2022 and higher inflation is weighing more heavily on consumers.
Credit card debt is piling up, reaching roughly $1.13 trillion. This is a record on a nominal basis, and when adjusted for inflation only 9.5% lower than the time-series high in late 2008, Figure 2.
The steep increase in credit card debt since 2022 is worth monitoring, as is consumers’ ability to manage their minimum required payments and the high cost of carry.
The New York Federal Reserve’s monthly Survey of Consumer Expectations found consumers increasingly concerned about making minimum debt payments during the next three months. The highest share of concerned consumers was 40 and younger, but those between the ages of 40 and 60, Figure 3, showed the sharpest increase. This is significant because the middleaged cohort has a low unemployment rate compared to the overall national average.
For now, U.S. households are managing debt. Household debt service payments as a percentage of disposable income was low, 9.8%, at the close of 2023. Since 1981, household debt service payments as a percentage of disposable income averaged 11.8% at the start of every recession.
Consumers also are saving far less than normal, 3.6% compared to the 10-year, pre-pandemic average of 6.2%. While the U.S. economy remains strong, cracks are slowly showing.
Government Debt and Interest Rates
The U.S. consumer has benefitted from government stimulus programs, student loan forgiveness and other actions that, to date, have served as a buffer to the Federal Reserve’s restrictive monetary policy. It also carries a cost. The U.S. government is expected to run trilliondollar deficits out to 2034.
That is concerning enough. But there also is the risk of upward pressure on interest rates if the supply of Treasury securities continues to grow.
When Treasury rates rise, investors tend to prefer low-risk government bonds to riskier investments. To compete for bond investors, businesses must offer higher rates, leaving less money for capital reinvesting.
Financial Conditions and the Stock Market
In March, the Federal Reserve released a Quarterly Summary of Economic Projections that included an expectation for lower real GDP in 2024, inflationary pressure until 2026 and an unemployment rate hovering near 4%.
It also appeared the Fed would stay the course and based on its December projection, potentially cut the federal funds rate three times in 2024, each the equivalent of 25 basis points. That looks less likely in recent weeks, with stronger-than-expected inflation and economic data.
Market expectations have not aligned with Fed signals. At the start of the year, investors anticipated six, 25-basis point equivalent rate cuts in 2024. As of April 17, 2024, market expectations dropped to one cut. The shift in market expectations is shown in Figure 4.
The resilient and robust economic outlook played a factor in the recent stock market rally. The S&P 500 has increased roughly 11% since the start of 2024 and 23% from the first quarter of 2023 to the first quarter of 2024. Combined growth in the S&P and wages increased the net worth of households by 9.2% between Q3 2022 and Q4 2023.
Lending Standards
As the Federal Reserve raised interest rates, beginning in 2022, banks tightened lending standards, including requiring more collateral and stronger credit standing to qualify for a loan. Figure 5 shows the growing share of banks that tightened standards on commercial and industrial loans.
The Federal Reserve’s rate hikes also had their intended purpose of lowering inflation. So far, the Fed’s tight monetary policy hasn’t tipped the U.S. economy into recession. Markets were optimistic that the Fed would cut rates in 2024, possibly as early as the first quarter. This optimism always was out of step with Fed statements.
In an environment of easing interest rates, banks generally expect increased credit demand. A January survey from the Federal Reserve showed a decline in the share of banks tightening lending standards for commercial and industrial loans to large and middle-market firms. The share fell from about 34% to 14.5% (Figure 5) in the last half of 2023, despite the Fed maintaining rates and the federal funds effective rate at its highest level in more than two decades. In fact, the share of banks with tighter standards was lower in Q4 2023 than most of 2022, when the Federal Reserve started hiking rates from record-low levels.
The expectation of rate cuts and the resilient economy factored into the stock market rally this year. As Figure 6 shows, there has been a relatively moderate, inverse relationship between the share of domestic banks tightening lending standards and the performance of the S&P 500. It is important to note that the axis for the S&P 500 is inverted meaning a decline in the blue line shows positive year-over-year growth.
The expectation of rate cuts also tends to drive demand for credit from consumers and businesses looking to expand. Conversely, when lending standards tighten, there is a tendency for the market valuation of the S&P 500 to decrease. Investors grow concerned in a rising rate environment that the Federal Reserve’s actions could slow economic growth to the point of recession.
The reality today is the economy still hasn’t fully digested the current rate environment. Economic data from the first quarter of 2024 pointed out that the Federal Reserve hasn’t accomplished its goal of controlling inflation.
The result: Markets likely will be more volatile and economic conditions tighter than predicted at the start of 2024.
What This Means for Agricultural Producers
All the talk about rate cuts is premature. The market and economy will tell the Federal Reserve when to adjust policy, not the other way around. This means the market must navigate the current rate environment.
Producers should build scenarios that account for no rate cut up to three cuts of 25 basis points each. However, based on today’s economic data, focus on the impact of fewer to no rate cuts in 2024.
Today’s prime rate is 8.5%. Three rate cuts equivalent to 75 basis points would put prime between 7.5% and 7.75%, assuming the 30-year average spread between the fed funds rate and prime holds. If rates are kept higher for longer, interest rate savings will be nominal in 2024.
In this environment, producers need to focus on financial efficiencies for their operations. It is unlikely that significant costs savings will occur through lower interest rates this year, so it is important for producers to generate revenue while controlling costs.
Below are three financial efficiency ratios for producers to consider.
The first ratio to benchmark is the operation’s interest expense ratio:
(Interest Expense/Gross Farm Revenue) x 100
The interest expense ratio shows how much gross farm income is used to pay for borrowed capital. The lower the interest expense ratio the less reliant a farm is on borrowed capital and the lower its cost of debt. A ratio of less than 10% is desirable; 10% and 16% is stable; and the ratio is at higher risk above 16%. If your operation’s ratio is at higher risk, look for ways to reduce borrowed capital.
Next, know your operation’s expense ratio:
((Operating Expense – Depreciation – Interest)/Gross Farm Revenue) x 100
This ratio shows the proportion of farm income used to pay operating expenses, not including principal or interest. The lower the ratio the more efficient the farm is at utilizing inputs during production. A desirable ratio is less than 65% and 65% to 80% is stable. Above 80% may be considered higher risk, indicating a farm is overleveraged with operating expenses.
Finally, with commodity prices declining faster than many input costs, producers need to track how efficiently they are using all their inputs during the production year. The net farm income from operations ratio is a good benchmark:
((Net Farm Income from Operations/Gross Farm Revenue) x 100
This ratio shows how much income is left after all farm expenses are paid. A higher ratio suggests efficiency. Aim for a ratio greater than 15%.
While each operation is different and contains a different commodity mix, these ratios serve as recommended benchmarks. Producers should utilize these ratios and recommendations as planning insights with the goal of staying ahead of potential financial challenges.
