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CHICAGO, May 3 (Reuters) - U.S. grain farmers have enjoyed a rare combination of soaring prices and land values since 2009 but if incomes dip as expected they should be careful not to fall into the trap of borrowing against inflated land values, the Kansas City Federal Reserve said in a report on Friday.
"In 2013, historically high farm incomes are projected to keep U.S. farm debt and leverage low. Yet longer-term projections suggest that farm incomes could fall dramatically in 2014," the study, entitled "The Wealth Effect in U.S. Agriculture," stated. "If agriculture's historical wealth effect holds true, farm enterprises might use existing wealth to finance and smooth investment spending, sowing the seeds for another round of debt accumulation."
The authors, Kansas City Fed Vice President Jason Henderson and Kansas City Fed economist Nathan Kauffman, cautioned that "the stage is set for another wealth effect and leveraging cycle in U.S. agriculture."
On the one hand, they said, expanding global population and rising incomes in developing nations are boosting demand for agricultural commodities. Farmers in top exporters like the United States - the largest grain exporter - have been increasing production through capital investments in equipment, irrigation and storage.
"As a result, projections of farm profits indicate that the combination of rising supplies and higher production costs could cut farm profits by 2014," the study said.
Looking at past farm booms and busts, such as the 1910-1920 and 1970-1980 periods, U.S. farmers built debt even as incomes fell and interest rates rose. By contrast, with the record grain prices of recent years, fueled not just by hungry overseas buyers but the domestic biofuels boom, grain farmers have reaped not just record profits but retired debt - and seen asset values soar as land prices set new records. But that overall wealth effect is a warning sign, the authors say: farmers tend to accumulate more debt when wealth levels are high.
"High wealth levels increase the amount of collateral available to underpin farm borrowings," the Fed study notes. "Today, an increase in farm debt may signal the beginning of another turning point in farm debt and leverage. After rising less than 1 percent annually since 2008, farm debt outstanding at commercial banks rose roughly 5 percent in the fourth quarter of 2012 for both real estate and non-real-estate debt. Similarly, Farm Credit System lending for real estate mortgages and production and intermediate-term loans rose 5.7 percent during 2012."
That bodes ill for farm solvencies, the authors say, given prospects of lower farm incomes and higher interest rates.
After posting record highs the past two years, U.S. government projections suggest farm profits will erode over the next decade, the study notes. With a return to more normal weather, a rebound in U.S. and world grain production is expected to build supplies - and pressure prices. Combined with other types of farm production, the USDA projects U.S. net farm incomes to fall 20 to 25 percent below 2013 highs during 2014 and remain near these levels over the next decade, the authors say.
At the same time, the Federal Reserve has said that interest rates could begin to rise during this period of lower incomes. Currently, most of the Federal Open Market Committee (FOMC) members of the Federal Reserve indicate that keeping the fed funds rate below 1 percent is appropriate policy through 2014, the study notes. "However, there is less consensus on future interest rate policy, as some FOMC members indicate that the fed funds rate should rise above 3 percent by 2015," it says.
"History has shown that a combination of falling profits and rising interest rates drive farmland prices lower," the study states. "History also has shown that when land values and farm wealth fall, solvency issues and farm bankruptcies rise."
The authors caution against the certainty of such long-term projections. They note that current farm debt ratios remain near historical lows. Yet projections of lower farm incomes, high wealth and low interest rates "are the recipe for another wealth effect in U.S. agriculture."
The lesson for farmers, the authors say, is to preserve capital and not go overboard on debt to guard against a sudden fall in asset values like land.
"Working capital is the first line of defense farmers can use to manage through periods of weak profitability," the study said.