At a recent Executive Producer Roundtable summit in Spokane, WA, participants asked Ed Seifried and I the question, “What is a normal level of interest rates?” Today's agricultural producers and businesses have been managing their businesses through an extended period of low interest rates. For example, the prime rate has remained at 3.5% for nearly four years. With the Federal Reserve's statement that they would keep rates low through 2014, this would be an unprecedented period of low interest rates.
Historically, the prime rate has been much higher. For example, from 1997 to 2001, the prime rate ranged between 7.75% and 9.5%. The terrorist attacks of 2001 resulted in the great dive to 4-4.75% for three years, before the prime rate picked up steam from 2004 to 2007, when the rate was between 5.25% and 8.25%.
Using this historical perspective on interest rates, one would surmise that the federal funds rate, which is currently at 25 basis points, would rise to 3.5-4% in normal times. The rule of thumb is that the prime rate averages approximately 3 percentage points above the federal funds rate. This would peg the prime rate for preferred borrowers at 6.5-7%.
I predict that the next spike in interest rates will be a movement toward “normal” rates, rather than the historical perspective of 19-20% interest rates in the early 1980s. The cash flow of businesses and government entities with debt on variable rates would be hit dramatically with higher rates. For example, a spike in the variable interest rate of a $500,000 line of credit could add $20,000 annually to the cost of production, or up to $40/acre on 500 acres of crop production. A 4% higher interest rate on the national debt would increase federal expenditures by $600 billion, amounting to 16% of the federal budget.
One of the critical aspects in planning on a farm or ranch business is to conduct scenario testing of interest rates. If interest rates go back to “normal,” it would be good for savers, but critical for those carrying large amounts of debt on variable interest rates.
Signs that interest rates may increase:
- Core inflation rate above 3% and headline inflation above 5%.
- Unemployment rate dropping to between 6% and 6.7%.
- Foreign creditors, which finance 41% of the federal debt, reducing their U.S. holdings and investing in other nations, therefore increasing interest rates on the U.S. debt.
Editor’s note: Dave Kohl, Corn & Soybean Digest trends editor, is an ag economist specializing in business management and ag finance. He recently retired from Virginia Tech, but continues to conduct applied research and travel extensively in the U.S. and Canada, teaching ag and banking seminars and speaking to producer and agribusiness groups. He can be reached at [email protected]