There are several significant changes in the American economy, and around the world, that could affect interest rates. The devalued dollar, the federal deficit and increasing commodity prices are factors. For farmers, what's really important is the “real” interest rate — the cost of money after stripping out the percentage that compensates investors for inflation.
Today, real rates are extremely low for short-term borrowing and about average for long-term borrowing. The federal funds rate of 1% minus the 2% inflation rate leaves a real federal funds rate of -1%. Historically, this figure runs 3% above the inflation rate. So we could see a 4% rise in short-term rates to get back to normal. Add to that the possibility of increased inflation and it makes rates even higher.
Traditionally, 30-year government bonds are also 3% over the inflation rate. With 30-year bonds at 5.03%, long-term “real” rates are about normal.
How high could rates rise? Brace yourself. Assuming the high productivity growth, real long-term rates needed to stabilize the economy over time would need to be 4.5%. That's according to William Poole, president of the Federal Reserve Bank of St. Louis, in a November interview. Assuming inflation could increase to 2.5%, that would imply a 7% market rate for 30-year Treasuries. Poole's estimates imply a 6% federal funds rate — a 5% increase from current levels.
Add the possibility of higher inflation due to a rising Commodity Research Bureau (CRB) index and the rate increase could be dramatic. Has this happened in the past? In 1993 the real federal funds rate was -0.3%. By 1995 it was 3.3%.
I'm also concerned about market psychology. No one seems concerned about rising rates. I still see many farmers taking the variable-rate option on real estate loans because it's cheaper and they can save money in the short run. That could haunt them in the long run.
Many clients and readers ask how to lock in an operating loan rate for more than one year to take advantage of current low rates.
Most lenders only lock an operating loan rate for up to one year. Here is a debt restructuring option that can reduce interest rate risk on your operating debt.
You might consider terming out a portion of your operating debt for five years and securing it with machinery or land. You can fix it at a favorable rate, now at about 5-6%. This is one way to fix the rate on a portion of your operating debt.
There are caution points if you do this, however.
Make sure there isn't a prepayment penalty on the term loan so, if you have extra cash, you can pay the loan off early.
Keep your remaining operating debt very low and operate on cash for a portion of the year if you can. A good guideline for your operating debt level is your working capital (current assets minus current liabilities) should be greater than 50% of your annual operating expenses, living expenses and payments. It's important that you monitor and stay in control of your financial health. It's not your lender's responsibility to do this.
Moe Russell is president of Russell Consulting Group, Panora, IA. Russell provides risk management advice to clients in 15 states. For more risk management tips, check his Web site (www.russellconsultinggroup.net) or call toll-free 877-333-6135.