Why Good Risk Managers Should Monitor Inflation

October 10, 2017 10:43 AM
Why Good Risk Managers Should Monitor Inflation

A farmer once aptly summarized the real-world effects of the academic-sounding term known as inflation: “My net worth in 1982 nominally was the same as it was in 1972,” he told Joe Atwood, now an economics professor at Montana State University, in the 1980s. “I am a lot worse off because of the decline of the purchasing power of my dollars.”

In short, when inflation goes up, the buying capacity of a unit of money goes down. It is measured in annual percentage change. Inflation has slowed in 2017 across the U.S., according to Federal Reserve Chairman Janet Yellen. Reasons for the decline could include changing workforce demographics, globalization or the rise of cheap online marketplaces. Yet inflation is an important factor for producers to grasp to manage associated risks. The farmer’s comments about inflation in the 1980s led Atwood to study just how much inflation affects producers. Turns out, inflation can distort financial statements, drive up land prices and influence cash flows on crop receipts.

“When it starts to happen, it affects commodities at different times,” Atwood says.

Grain Versus Land. Historically, the price paid for a unit of any commodity have gone up less than the rate of inflation. For example, 1 bu. of wheat has less purchasing power today than it did in 1918. That explains the push for parity pricing in the ’80s, when inflation soared to record highs. Yet because of increases in yield potential, an acre of land still generates roughly the same nominal revenue it did nearly 100 years ago.

“Real prices have trended down for a long time, and yields have been trending up, and those two compensate,” Atwood says. “A bushel of wheat will not buy what it did in 1918, but an acre of land is a different story.”

The nominal value of land tends to go up roughly at the rate of inflation in the long run. Inflation also complicates producers’ ability to understand what’s going on with costs and receipts.

“The income off of an acre of a land generally will go up with inflation,” Atwood explains. “The purchasing power of an acre of land exhibits no long-term real trend.”

Commodity prices can be directly affected by inflation in the short term, as well. When investors feel commodity markets are undervalued because they are anticipating an increase in inflation, they often “pour fresh money” into the markets, pushing prices higher, says Alan Brugler, president of Brugler Marketing & Management.

Interest Rates Sway. Inflation also influences interest rates. Suppose a farmer has an operating loan with a 2% interest rate. During the life of the loan, inflation jumps 3%. As a result, the interest rate is now 5%.

“It causes cash-flow problems that aren’t necessarily an indication of unprofitability,” Atwood explains. Like producers, the Federal Reserve watches inflation. The central bank has a goal for inflation of 2%, says Nathan Kauffman, assistant vice president and Omaha branch executive with the Federal Reserve Bank of Kansas City. In recent years, inflationary pressures have remained relatively low and slightly under this goal. When the Fed determines whether to increase interest rates, they use inflation as one way to gauge the economy’s health

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