Aug 16 (Reuters) - The price of prime farmland in the drought-hit U.S. Midwest grain belt rose 1 percent in the second quarter, the smallest quarterly increase in two years, the Federal Reserve Bank of Chicago said on Thursday.
But while the district's worst drought in nearly a quarter century will dramatically shrink soybean and corn output, land values this quarter were not expected to fall, the Fed said in its quarterly survey of 205 bankers in the district.
The Chicago Fed district includes the heart of the U.S. Corn Belt states of Iowa, Illinois and Indiana, and parts of Wisconsin and Michigan.
"The drought did not seem to have stifled all the momentum of rising agricultural land values," the Chicago Fed said in its August Ag Letter.
Just 4 percent of those surveyed expected farmland values to drop this quarter; more than 70 percent see farmland markets leveling off.
"Coming after several years of farm income that were better than average, the drought should not reverse the gains in farmland values, but there could be a pause while expectations about future earnings from crop production adjust to the short-term effects of this summer's drought," the Fed said.
The value of district farmland rose 15 percent from a year earlier, the report said, a rise that "seems modest only in the context of exploding farmland values over the past few years."
In the Chicago Fed district, Iowa and Illinois combined produce about a third of the domestic corn and soybean crops. The United States is the world's leading exporter of those food and industrial crops.
Farmland values are closely watched by Federal Reserve economists and by commercial bankers as a barometer of U.S. banking assets and as a benchmark for agricultural balance sheets. Farmland is a basic collateral for farm loans.
The Kansas City Federal Reserve's quarterly farmland survey on Wednesday showed values across Kansas, Oklahoma, Nebraska and parts of Missouri rose 3 percent from the prior quarter.
While the drought in the Chicago Fed district is considered the harshest since 1988, the wider drought affecting the rest of the Midwest and the Plains states has been called the worst one in 56 years.
CREDIT CONDITIONS LEVEL
Higher crop prices and crop insurance payments will partially offset the drought's impact, but the drought -- the worst in the district since 1988 -- has hit livestock operations particularly hard, the Fed report said.
Higher feed costs and the lack of extensive insurance coverage for corn and soybean prices have cut dairy, hog, poultry and cattle enterprises.
The district has already incurred "severe losses" in farm income in 2012, the Chicago Fed report said.
Still, agricultural credit conditions in the Corn Belt were resilient, with funds availability at a record high, and repayment rates for non-real-estate farm loans improving.
While interest rates on agricultural operating loans and mortgages set new lows, demand for non-real-estate loans was "feeble" compared to a year ago, it said. The average loan-to-deposit ratio, at 68.1 percent, was 10 percentage points below the average level that respondents said was optimal.
A few bankers thought repayment problems would increase because of the drought, the survey said. Respondents expected overall non-real-estate agricultural loan volumes to fall this quarter compared with a year ago, while farm mortgage volumes were forecast to rise slightly.
The Fed said that Iowa farmland values remained the strongest in the district with a year-over-year increase of 24 percent.
Land values in Illinois, Indiana and Wisconsin were up 15 percent, 12 percent, and 13 percent, respectively. (There were too few responses in Michigan to generate data this quarter, it said). Non-real-estate farm loan volumes were expected to rise in Indiana and Wisconsin, the report said.