* Uncertainty in tax policy spurred year-end farm sales
* Midwest bankers expect farmland to say strong in Q1
* Kansas City Fed to issue is farmland survey Friday
CHICAGO, Feb 14 (Reuters) - Farmland prices in the U.S. Midwest Corn Belt states rose 16 percent in the fourth quarter of 2012 from a year earlier, setting new all-time highs as demand for farmland remained strong despite the worst drought in 50 years, the Federal Reserve Bank of Chicago said on Thursday.
The Chicago Fed's quarterly survey of bankers showed prices of good farmland in the October-December period notched the third largest year-on-year increase since the late 1970s. Farmland values gained an average 7 percent from the prior quarter.
In 2012, an index of inflation-adjusted farmland values once again established a record for the regional district, as it has every year since 2007, the bank said.
"Toward the end of 2012, the increases in farmland values seemed to pick up their pace ... amid reports of strong farmland sales in the face of impending and uncertain changes in federal tax policies," the bank said of its survey, which draws on comments from 212 district bankers in Iowa, northern Illinois and Indiana as well as parts of Wisconsin and Michigan.
Farmland values in the central United States are closely tracked by government economists as a gauge of the U.S. economy and health of the banking system.
In recent years, both crop prices and farmland prices have set records as the burgeoning biofuels industry and record food exports spotlighted the value of hard assets. In turn, farm income has also set records.
The Chicago district survey follows the St. Louis Fed quarterly update, which reported strong farm income and land values on Wednesday. The Kansas City Fed will issue its survey on Friday.
"Perhaps the most surprising aspect of 2012's strong gain in farmland values was that it occurred in the midst of the worst drought in the Midwest since 1988. Although by some measures last year's drought was more severe than 1988's, the losses at harvest in 2012 were not as significant as those experienced in 1988," the Chicago Fed said.
The district produces about a third of all U.S. corn and soybeans as well as soft wheat, sorghum and other crops. It also has leading swine and dairy operations. USDA has estimated the district's corn harvest was the lowest since 2002 and soy harvest lowest since 2007.
But the bank said crop insurance and drought-induced jumps in grain prices buoyed farmer returns, with corn and soybean prices up about 11 percent on average from 2011.
The flip side of that strength hit livestock farmers the hardest as soaring feed costs and lower milk and hog prices stressed producers.
"The squeeze on livestock producers was evident in the most recent estimates of farm assets by the USDA. Following a 3.6 percent slide from 2011, the 2012 value of the national stock of livestock and poultry was the lowest in real terms since 1960, when the data start," the Fed said.
Still, for farm bankers the overall strength in grain farmer returns in 2012 continued to outweigh losses or liquidations from loans from livestock operations, the Fed said.
Credit conditions improved in the fourth quarter and additional funds were available to lend, with bank deposits boosted by crop sales and insurance indemnities.
"As of early February 2013, $3.93 billion had been paid out for insured 2012 agricultural losses in the five District states (29 percent of the U.S. total of $13.7 billion)," the Fed said.
BANKERS MORE CAUTIOUS, TIGHTEN CREDIT
But bankers were growing more cautious, according to the survey, with interest rates remaining at record lows.
Almost 20 percent of the banks surveyed tightened credit standards for ag loans in the fourth quarter of 2012 versus a year ago while just 1 percent eased credit standards. Ten percent of the banks raised the amount of collateral to qualify for non-real estate farm loans, the Fed said.
Non-real estate farm loans were expected to contract in the first quarter of 2013. The exceptions were operating loans, which were predicted to expand, and farm machinery loans, which were forecast to hold steady. Bankers also expect a higher volume of real estate farm loans.
Farmers' capital expenditures - including spending on machinery and equipment, trucks and autos, and buildings and facilities - were forecast by respondents to be even higher in 2013 than in 2012.
The survey showed that while 71 percent of bankers expected farmland values to be stable from January to March, 28 percent expected values to increase in the first quarter.
"With the USDA predicting net farm income to rise 14 percent from 2012 to $128.2 billion in 2013, there would seem to be at least another leg to be run as farmland values continue their upward race," the bank concluded.
Drought severity had diminished in much of the central Midwest following the harvest, giving more hope for a rebound in crop yields. Recovery from the drought will remain a key factor in 2013, as the movements of drought influenced crop prices will affect both crop farmers and livestock producers, the bank said.