Low unemployment, rising wages and, by extension, strong consumer spending seems like ideal economic conditions. Except when these conditions continue to feed inflation. The Federal Reserve has spent more than a year hiking the federal funds rate in an effort to cool a hot U.S. economy.
Agricultural producers have felt the pain of both rising production costs due to inflation and higher interest rates as a result of the Fed’s monetary policy. The Fed actions appear to be having an impact. But is it enough? Is it taking the U.S. economy in the right direction?
Our economist, Matt Erickson, looks at what interest rate forecasts and macro-economic indicators mean for producers and their 2024 planning.
- The federal funds rate, unchanged since last July, sits between 5.25% and 5.5%. At its December meeting, the Fed signaled the potential for an equivalent of three rate cuts of 25 basis points each in 2024. Meanwhile, the CME FedWatch Tool, a gauge of the market, projects six cuts in 2024, each 25 basis points.
- Two factors give the Fed reason to keep interest rates higher for longer – a tight labor market and strong wages. The unemployment rate currently stands at 3.7%, marking 23 consecutive months below 4%. However, the Fed does expect unemployment to be just above 4% through 2026.
- In addition to higher unemployment and lower interest rates in 2024, the Fed projected at its December meeting that real GDP growth is expected to slow sharply in 2024. Real GDP will begin to slowly increase through 2026.
- In this environment, producers need a working capital management plan, as well as a clear understanding of their operation’s debt commitment and tolerance levels.
Interest Rate Drivers: Inflation and Labor
Inflation above the Federal Reserve’s 2% target and a tight labor market contributed to the rapid and repeated interest rate hikes of 2022 and 2023. Other than the brief period from late-2018 through 2019, the federal funds rate was higher than inflation, which means the rate was negative in real terms. As Figure 1 shows, the Fed’s more restrictive policy has returned rates to a more historical standard in which they exceed inflation.
Do not expect the Fed to abandon its restrictive rate policy in 2024. Inflation and a tight labor market will remain a reality. However, both economic conditions are trending in the right direction. This could help the Fed achieve its dual mandate of maintaining maximum employment and price stability in the market.
The Fed’s preferred gauge of inflation is the personal consumption expenditure (PCE) price index. In November, the index was up 2.6% compared to the same month in 2022. Core inflation, which excludes food and energy, was up 3.2% for the same period. The Fed’s 2% target is tied to core inflation, which has either declined or held steady for 10 consecutive months.
Service inflation, by comparison, has proven more stubborn, rising 0.2% from October to November. This is because of a shift in consumer behavior away from goods to services. The tight labor market continues to benefit consumers through wage growth.
The unemployment rate has been under 4% for the longest stretch since 1967 and leading into the recession of 1970. In November 2023, there were 1.4 job openings for every unemployed person. This was down from the March 2022 peak of more than two job openings per unemployed person and represented an 18% drop from November 2022. Still, job openings remain more than 25% above pre-pandemic levels of February 2020.
In December, average hourly earnings for all private-sector employees grew 4.1% compared to the same month in 2022. Between November and December, the last available reporting period, wages increased more than 0.4%. Wage growth is expected to soften, due at least in part to more workers staying at their jobs and job openings declining.
All Eyes on U.S. Consumer in 2024
Several important economic trends emerged from the Federal Reserve’s Quarterly Summary of Economic Projections, which was released in December. If the trends play out as the Fed expects, look for lower real GDP growth, lower inflation and higher unemployment. Also, the Fed held out to the possibility of three reductions equivalent to 25 basis points each in 2024 – 75 basis points lower than the market’s expectation of six cuts of 25 basis points each.
Much of what will transpire depends on the financial resiliency of the U.S. consumer, whose spending exceeded expectations in 2023 and continues to show strength in early 2024.
The U.S. is a consumer driven economy and money to support consumption must come from somewhere. One measure is the consumer’s growth in real disposable income. Real disposable personal incomes on a per capita basis increased approximately 0.4% from October to November and 3.7% year-over-year. This signals strong resiliency. For perspective, at the start of all nine recessions since 1959, real disposable income growth per capita averaged 1.7%. Elevated wages, combined with lower inflation, have provided consumers with additional purchasing power to help them maintain their financial resiliency in the market.
Consumer debt has risen to more than $17.3 trillion, a record on a nominal basis. However, adjusted for inflation, total U.S. consumer debt is below the highs of 2008 (Figure 2). Household debt service payments as a percentage of disposable income also remains low at about 9.8% (Figure 3).
All this means that, at least for now, consumers are able to manage debt. Strong wage growth is only one contributing factor. Many consumers also locked in lower long-term financing prior to the 2023 rate hikes and benefitted from COVID-19 policies, including government stimulus payments and a hold on student debt payments.
Cracks in the consumer picture have set in. According to the Federal Reserve Bank of New York, auto loan and credit card debt that has transitioned into serious delinquency status (90-plus days) is at its highest level in more than a decade. U.S. consumers also are saving far less than normal – just above 4% compared to a 10-year average of 6.2% pre-pandemic.
Low savings, combined with the higher cost of carrying debt, is a concern. But the wildcard in 2024 is student debt – the largest non-housing debt balance for U.S. consumers at $1.6 trillion.
Payments on student debt were paused, free from interest accrual, for most of the past three years, resuming only as of October 1, 2023. About 60% of the 22 million borrowers with payments due in October paid by mid-November, according to the most recent data from the Department of Education. The delinquency status won’t be clear until late this year, after missed federal student loan payments are reported to credit bureaus. This is an important data point to monitor.
Economic signals from Bond Market
The combination of a strong labor market and wages, recent government stimulus payments and years of historically low interest rates have so far limited the impact of the Fed’s restrictive monetary policy. In fact, the Fed projects core inflation will remain above its 2% target until 2026.
As fear of a U.S. recession faded in 2023, analysts began talking about a soft economic landing. But it’s too early to celebrate a soft landing as long as the Fed is committed to achieving 2% inflation with policy decisions driven by data. The most recent labor and wage data is driving speculation that the Fed may not cut interest rates as quickly as the six, 25-basis-point reductions anticipated by markets.
One indicator worth watching is the bond market. Since July 2022, the rate on a monthly average on the 2-year treasury has exceeded the rate on the 10-year treasury, meaning rates are lower on longer-term bonds. Historically, an inverted yield curve has been a good predictor of recession; it is indicative of interest rates being too high in the short-term, which can lead to economic stress and force yields in the future to move lower.
The re-steepening of an inverted yield curve from its trough can provide insight into the timing of recession. Since 1977, an average of nine months passed from trough to recession. In July 2023, the yield curve averaged -0.93 basis points, the highest inversion since September 1981. If July proves to be the actual “trough” of this inverted yield curve cycle, the U.S. economy has only experienced five months of longer-term rates converging with shorter-term rates.
The re-steepening of the yield curve also generally points to a greater likelihood of increased borrowing costs, tighter credit and lending standards, a slowdown in the labor market, slower wage growth, and weaker economic activity. To some degree and at varying paces, the U.S. economy is experiencing some of these conditions today.
What This Means for Producers
Could the U.S. economy experience a soft landing? Sure. Consumers are somewhat protected from the Fed’s rate hikes by the combination of government stimulus, long-term refinancing opportunities, strong wage growth and extremely low bond yields. At the same time, fear of inflation or recession drives investors to 10-year treasuries, which causes yields to fall below short-term securities. However, that has not been the trend. Longer-term yields have risen.
History provides little guidance for today’s economic environment; markets haven’t seen anything like current conditions. And of course, 2024 holds two major unknowns – the 2024 election and the impact of U.S. debt coming onto the market.
There are lots of questions about what this means for a possible recession. The New York Fed’s Yield Curve Recession Probability Model gives a 71% chance of recession by May 2024 and almost a 63% chance by December 2024.
While recession would be bad for the U.S. economy, producers face a more immediate concern: How can I best position my operation against uncertainty and risk? Given the rising trajectory of consumer debt and the historical significance of leading recessionary indicators flashing warning signals, I would be on top of my risk management plan for 2024.
Agriculture also must be prepared for the likelihood of lower commodity prices. In a downturn of any commodity cycle, it is important to prioritize your working capital management plan. Preserve as much working capital as possible, treating it as a risk management option.
Analyze your working capital against your gross revenue and work with your Farm Credit advisor to develop a solid plan. Then take that management plan a step further: How much working capital is needed on a per unit (e.g., acre or head) basis?
Next, be intentional about understanding your operation’s level of debt commitments and what it can tolerate. One good measurement is the debt-service ratio -- net (farm) income to the operation’s annual debts and obligations.
Be mindful that a few strong years of net farm income, including elevated levels of ad-hoc government payments, can provide an overly positive picture. It would be advantageous to analyze this ratio over a longer term. Preferably, calculate the operation’s annual debt payments on a per head or per acre basis.
Understand both your cost and revenue structure and apply this information to your scenario planning. The business of agriculture is a high cost, low margin environment. Think about your cost structure and debt load carefully for 2024. The prime rate today is 8.5%. The Fed signaling cuts equivalent to 75 basis points would put prime between 7.5% and 7.75%. This, of course, assumes 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. Understanding different cost and revenue scenarios will allow you to understand your overall margin and breakeven and when you need to act in the market.
In any cyclical business, downward cycles eventually bring opportunity. Operations that manage debt levels while keeping working capital on solid footing tend to come out strong and are better able to seize opportunities once the market shifts.