The Potential Costs of Lower Inflation

 

When it comes to inflation and capturing pricing opportunities, remember that, in some ways, it’s business as usual. Think about selling when prices are rising. Don’t wait too long to sell as prices start to recede. However, bear in mind that inflation can amplify the price of commodities, both upward and downward. Furthermore, commodity prices are generally the first to be affected by inflation, so you need to act more quickly than other industries.

How closely do inflation and prices align? Consider the chart below, which tracks inflation and the price of corn, demonstrating how you can generally expect better crop prices as inflation increases, and lower crop prices as inflation pulls back. For example, in April 2022, old crop corn hit a high of $8.245 (July 2022 contract) as annualized inflation (Consumer Price Index) topped out at about 7%. Current inflation is essentially halved at an annualized 3.4%, and the price for old crop corn (March 2024) is also cut almost in half at $4.4625.

What are the implications if inflation continues to fall? Everything else being equal, there is more potential for prices to continue to fall, which means it’s possible that prices right now are high compared to what they could be in the future. Unfortunately, unlike falling prices in a stable inflation environment, you still have to manage the potential fallout of raised inflation, including a higher imbedded cost structure, higher interest rates, and a greater risk for a recession. All of these factors, of course, have huge implications for on-farm profitability. Let’s discuss the continuing potential and real costs of inflation and how that could influence your strategies.

 

1.  Increased costs of production due to inflation are most likely permanently imbedded in your cost structure.

Ever since inflation spiked, the costs for everything on average have gone up fairly substantially. Still, many people are frustrated that costs haven’t returned to normal as inflation has receded. In other words, it feels like this supposed decrease in inflation isn’t real. That’s because, contrary to popular belief, prices are not receding – they’re continuing to increase in spite of the decrease in the rate of inflation. Here’s why:

  • A decrease in inflation means that the costs for goods and services rise more slowly than they do under a higher inflation rate – it doesn’t mean that overall prices return to where they were. To put it more bluntly, in a growth (non-recessionary) economy, the costs today are now the normal costs.
  • Take a look at the chart below, which shows the past 10 years of annualized inflation rates. Rates prior to 2021 ranged from a low of 0.7% to 2.3% – we’re talking more than 100 basis points between the high end of that range and today’s annualized inflation rate of 3.4%. If it feels like prices haven’t settled, it’s because they continue to rise at a rate higher than we had been used to pre-2021 inflation.

  • The compounding effect of inflation on prices accelerates the pain of rising costs. Let’s use the numbers in the chart above to highlight that on a theoretical good costing $100 at the end of 2012.

Take a look at the rise in cost from 2012 to 2020. Over that 8-year period, the cost (rounded to the nearest dollar) would have risen $14. In contrast, the cost from 2020 to 2023 would have risen $20, where $5 of that increase happened in 2023 in spite of the lower rate of inflation. This is because of the compounding effect of the large jumps in price in 2021 and 2022. In other words, we continue to pay for previous jumps in inflation even in relatively low inflation environments. The lower you can get inflation, the less pain on top of pain.

  • Wishing for lower input costs is the same as wishing for even more pain, especially if the price of your grain falls at a faster pace than any reduction in the cost of your inputs. That’s because a reduction in the price of goods and services across the economy generally translates into deflation and a recession. The potential net result to you? Lower worldwide demand without a clear, substantially meaningful change to your cost structure.

 

2.  Fed action to control inflation affects the interest rates you pay

Speaking of the risk of recession, let’s revisit the consumer price index/inflation rate of 3.4%. Again, this rate is substantially better than the 7% high. Nonetheless, it’s still 1.4 percentage points above the Fed’s target rate of 2.0%, which would generally return us to pre-2021 inflation rates. The Fed has limited tools to try to get inflation further under control, and any action still has potential for some negative impact on your cost structure.

  • They can maintain or even increase the cost of lending. The market has indicated it expects a drop in rates in 2024. Before that happens, the Fed would theoretically want to spur a slowdown in economic activity, including slower demand and growth, and higher unemployment.
  • A higher interest rate impacts your cost of borrowing, which will offset any decrease in inflation on the costs of production to some unknown extent.
  • More broadly, the danger is the Fed overplaying its hand and flipping the soft economic landing that has been lauded to a harder recession. While this would likely help your (non-borrowing) cost structure, it could have a big downward effect on commodity prices, especially if weak economic activity in the U.S. spurred a larger weakening worldwide.

 

3.  In a higher interest rate environment, some strategies are riskier than they were in the past

As always, the intersection between fundamental factors like inflation and interest rates, and your strategies, is expected yield – both yours and globally. Right now, weather patterns have improved in South America and conditions have improved in the Plains for wheat. In the January USDA WASDE update, the USDA put the national 2023/2024 corn yield at a record 177.3 bpa, in dry weather! All of this speaks to the potential for ample stock, downward pressure on prices and a bigger spread between interest rates (cost of carry!) and price.

Case in point, the cost of carry to keep your grain in storage is higher than it was before. For instance, on an operating loan of 8%, the cost to carry $4.50 corn is 3 cents per month. Be mindful in this environment where U.S. carryout is increasing, and South America is (possibly) improving. It may take more for the market to rally to make up for the increased cost of money. Do you want to speculate? Can you afford to speculate?  If you lock in carry on a sale (for May) are you getting an extra 12 cents (four months of carry) for your corn?

  • If you’re self-financed, looking for a rate of return equal to the 30-day T-bill rate, that equals about 1.625 cents/mo. (4.5%)
  • Add in the cost of storage, commercial or self-owned, and the carry required increases.

Remember, when there are ample supplies, the market tends to price a carry in the market (as end users have plenty for now). Typically, this happens as funds sell the front months more aggressively than the deferred, keeping a lid on prices and rallies.

 

4.  It’s not all doom and gloom

We’ve laid out the potential negative impact of inflation on economic health to make sure that you prepare and weather a negative economic scenario brought on by inflation. However, there is also just as good a possibility that the U.S. will finish its soft economic landing and be in the position to reduce interest rates. If that does occur, we believe this scenario would be supportive of commodity prices.

Have a Plan – and Be Prepared to Take Action in Falling Prices

One of the worst feelings in the world is selling on a down day in the market. However, remember that a down day today might be the best day to sell if the market continues to decline. Given market conditions, you need to have a plan in place in the event of increased interest rates or market contraction as the economy continues to fight the aftermath of high inflation. As always, no one has a crystal ball on what the market will do. Build a plan to make sure you are positioned to capture price in any market environment. As we’ve discussed before, this includes:

  • Sell ahead of your crop if prices look good. Many farmers are concerned about selling a crop that’s not yet in the ground. Get beyond this by making some very conservative estimates and sell accordingly. Look at your production history over time and use the lowest number as a base for determining how much you can comfortably sell.
  • Use open sell orders at incremental predetermined levels that represent resistance (congestion) areas that are beneficial to your bottom line. (Don’t get greedy! This often leads to poor decision-making.)
  • Use stop orders and adjust them accordingly as the market rallies. This will help maximize profitability by minimizing missed sales opportunities.
  • Puts typically gain value as prices move lower. Buy put options to give yourself some downside coverage without the commitment of a sale (futures or cash).
  • Calls typically gain value as prices move higher. If the market is particularly violent and volatile, use call options to protect existing sales from higher prices and gain confidence to sell more bushels at higher prices. (This strategy can be used in conjunction with owning put options because the level of uncertainty can make either one pay off – sometimes both.)

 

Total Farm Marketing Can Help

 

At Total Farm Marketing, our consultants spend 100% of the day focused on the market, allowing farmers like you to focus on the job of farming. Talk to us about setting up a plan that can help you capture the highs, avoid the lows, and build a strong weighted average price.

 

Call us at 800.334.9779.

 

©February 2024. Total Farm Marketing. Futures and options trading involve significant risk of loss and may not be suitable for everyone. Therefore, carefully consider whether such trading is suitable for you in light of your financial condition. No representation is being made that scenario planning, strategy or discipline will guarantee success or profits. Examples of seasonal price moves or extreme market conditions are not meant to imply that such moves or conditions are common occurrences or likely to occur. Futures prices may have already factored in the seasonal aspects of supply and demand. The data contained herein is believed to be drawn from reliable sources but cannot be guaranteed. Reproduction of this information without prior written permission is prohibited. This material has been prepared by a sales or trading employee or agent of Total Farm Marketing and is, or is in the nature of, a solicitation. Any decisions you may make to buy, sell or hold a futures or options position on such research are entirely your own and not in any way deemed to be endorsed by or attributed to Total Farm Marketing. Total Farm Marketing refers to Stewart-Peterson Group Inc., Stewart-Peterson Inc., and SP Risk Services LLC. Stewart-Peterson Group Inc. is registered with the Commodity Futures Trading Commission (CFTC) as an introducing broker and is a member of National Futures Association. Stewart-Peterson Inc. is a publishing company. SP Risk Services LLC is an insurance agency and an equal opportunity provider. A customer may have relationships with any or all three companies.

Author

Scott Masters

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