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Regional Economist January 1997 Eighth Note Should the Fed Target the CPI? As Fed Chairman Alan Greenspan has been saying for some time, and the Boskin Commission’s recent report confirms, the consumer price index appears to overstate the cost of living by about 1 percentage point. If this estimate is accurate, then annual costof-living increases in government benefit programs and upward adjustments in tax brackets have been too high. Predictably, the political controversy surrounding this subject centers on whether we should correct the bias in the CPI to help balance the budget. But lost in the debate is another important question: Should the Federal Reserve use the CPI—biased or not— to define its price-stability objective? The answer, in my opinion, is yes. As the Boskin Commission reported, roughly half the bias in the CPI, called substitution bias, arises because current data-gathering methods fail to account for the public’s ability to shift its purchases quickly, in response to changes in relative prices. This bias can be eliminated, but only with a shifting of priorities or an increase in resources at the Bureau of Labor Statistics. The other half of the bias arises because it is difficult to account for new products and improvements to existing products. These issues are thorny and unlikely to be resolved anytime soon. Obviously, we should continue the debate about how to make the CPI as accurate as possible. That said, as a long-run objective for monetary policy, the CPI has several things already going for it. It is one of the most carefully constructed and timely of all economic measures. Moreover, it is widely recognized and often used in economic calculations and indexing arrangements. If we’re trying to achieve price stability in terms of cost of living, by definition we should be looking for CPI growth that is equal to its estimated bias. The CPI increased 3.3 percent in 1996. Subtract the 1 percentage-point bias in the measure, and you can see that we’re still 2.3 percentage points away from having stable prices. Let’s say, though, that the Fed were to set a 0 percent to 2 percent long-run objective for the CPI, and it ended up growing roughly 1 percent a year. We would then have effectively eliminated inflation. My point is that uncertainty about the best way to measure the cost of living shouldn’t keep us from the important task of choosing a price index to measure our progress toward price stability. As resources allow, I am certain that the BLS will continue to fine-tune the CPI. In the meantime, the Fed can define its price stability objective in a way that takes any known bias into account. 3 Thomas C. Melzer President Regional Economist January 1997 The OVERLOOKED The Rural Eighth Di s t r i c t O ver the past few decades, much has been made of the blight and subsequent revitalization of urban America.1 Many cities have witnessed population and job flight to the suburbs. To lure back many of these lost jobs and residents, local, state and federal governments have devised a wide range of incentives, usually involving infrastructure improvements or tax breaks for real estate development or new employment.2 Numerous cities have since rejuvenated their business districts. At the same time, however, scant attention has been paid to development in rural areas. Historically, farm policy had been thought of as constituting rural policy. But farming has changed over time, becoming much more sophisticated because of dramatic advances in technology.3 In 1960, farm output made up about 4 percent of all U.S. output; today it comprises only a bit more than 1 percent. Yet despite farming’s falling share of total output, rural areas have continued to record income and employment growth. Areas that were once thought of as primarily farmland are today much more diverse and, in fact, have been posting some of the B Y AD AM M. ZARETSKY nation’s strongest income and employment growth over the last 10 to 20 years, even though only 20 percent of the nation’s population lives there. Strikingly, though, 40 percent of the Eighth Federal Reserve District’s population lives in nonmetropolitan areas, making rural policy and development even more important in this area.4 A Snapshot of District Rural Areas Eighth District rural areas largely are agricultural. District states are home to almost one-fourth— about half a million—of all farms in the country. Missouri alone contains about 5 percent of the nation’s farms. But, because the farms in our District are generally about half the size of those in other parts of the country, they constitute only a little more than one-eighth of the nation’s farm acreage—about the same as in Texas. District farm output contributes just 2 percent to the region’s total output, making it slightly more important here than it is in the rest of the nation. 5 The somewhat greater presence agriculture has in the District, however, does not make this region more rural than others in the nation. The proportion of the region’s population that lives in rural areas is a more meaningful determinant of rural status. Not only does two-fifths of the District’s population live in nonmetropolitan areas, but this share also accounts for a whopping 23 percent of the nation’s nonmetropolitan population. In comparison, the District is home to only 14 percent of all of the nation’s residents. District urban and rural areas also have higher population densities than their national counterparts. District metropolitan areas, for instance, have about 325 persons per square mile, while the national average is about 290 persons per square mile. The difference is even more dramatic in nonmetropolitan areas: 45 persons per square mile in the District versus 18 persons per square mile in the nation, or about 2 1/2 times the density. This higher density makes the District’s rural areas attractive to businesses because of the larger-than-usual labor pool from which to draw workers. This gives these areas a relatively important role to play in the region’s overall economy. Rural Areas: Myths and Realities Because rural areas are usually characterized by farming—an industry of Employment in District Rural Areas Between 1974 and 1984, nonfarm payroll employment actually grew somewhat faster in the District’s rural counties than in its urban counties.5 For the most part, however, employment growth in urban and rural areas was slow, averaging about 1 percent a year during the decade. Individual states, however, differed in their growth patterns. For example, all District states except Illinois and Indiana had average job growth of more than 1 percent a year. Illinois and Indiana, which are in the Rust Belt, an area that suffered severe setbacks during this time, experienced employment growth that was about half a percentage point below the District norm in both urban and rural areas. Only in Kentucky and Missouri did rural areas create more jobs than urban areas. By the mid-1980s, the resurgence of job growth in the region was obvious. The District’s average growth rates were up a full percentage point from the previous decade. Arkansas, Mississippi and Tennessee—states in the southern part of the District which generally have lower labor costs due to less unionized labor forces, right-to-work laws and lower taxes—rebounded with stronger growth in both urban and rural areas. In all District states except Missouri, however, urban employment growth rates still outpaced rural ones, with some approaching 3 percent a year. Manufacturing as a Driving Force NOTE: Several small nonmetro counties in Arkansas, Illinois, Kentucky and Missouri are not included for some years. SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis dwindling importance in U.S. output—as well as a more tranquil lifestyle than that found in cities, a common perception is that they grow slower than urban areas. An examination of two different growth measures—employment and personal income—shows that, for the District, this perception has some validity. Growth rates in both payroll employment and per capita personal income have, in general, been slightly faster in metropolitan than nonmetropolitan areas, though the differences are often negligible. 6 What sustained job growth during the leaner mid- to late-1970s and drove much of the resurgence that followed? As the charts at left show, between the mid-1970s and mid-1980s, manufacturing employment levels fell in all District metropolitan areas, except those in Arkansas. This isn’t too surprising since manufacturing’s share of total employment has been declining nationally for decades, with some of the biggest hits taken in the 1970s. What is surprising, though, is that manufacturing employment levels in most states’ nonmetropolitan areas actually increased during this period. Only in the Rust Belt states did they decline. Thus, while almost all District urban areas were losing manufacturing jobs, the bulk of District rural areas were creating them. One explanation for this is better access to transportation from improved rural highways. Although growth rates in rural areas were admittedly low— less than 1 percent a year—the mild growth served to set the stage for the coming resurgence. Regional Economist January 1997 From the mid-1980s to the mid1990s, manufacturing employment took off in all District states’ rural areas, even those in the Rust Belt. Kentucky and Missouri, in fact, experienced an average growth rate of more than 2 percent a year. Although most states’ urban areas also added manufacturing jobs during this time, they came at a slower pace than in rural areas. Overall, many more counties added manufacturing jobs than lost them. About twice as many District urban counties had some manufacturing employment growth than had some decline. But about four times as many District rural counties experienced manufacturing employment growth as experienced declines over the period. Where did the strongest growth occur? The maps at right show those counties where average growth either increased or declined by more than 5 percent a year during the past 10 years. Only one District metropolitan county falls into the decline category, while about 30 percent of those that grew, did so at more than 5 percent a year. The split among nonmetropolitan counties follows a similar pattern. Only six rural counties witnessed a decline in manufacturing employment of more than 5 percent a year over the period. Here, too, almost 30 percent of those counties that grew did so by more than 5 percent, illustrating that they were not only adding manufacturing jobs during the decade, but also holding their own against their urban neighbors. This is significant since manufacturers had usually favored urban areas because of their better access to labor, transportation, financing and an established corporate community. MANUFACTURING EMPLOYMENT SUCCESS STORIES (AND FAILURES) 1984-1994 Me t ro p o l i t a n No n m e t ro p o l i t a n The North/South Divide About 17 percent of all current District employees work for manufacturing firms—marginally more than the 16 percent nationwide. Somewhat surprisingly, District nonmetropolitan counties have the higher concentrations of manufacturing workers—about 23 percent in nonmetropolitan counties compared with 15 percent in metropolitan counties. Both the nonmetropolitan and metropolitan District shares are lower than they were 10 years ago—four percentage points in the metro areas, one percentage point in nonmetro areas. As the figure on the next page shows, the nonmetropolitan counties in Arkansas, Mississippi and Tennessee are especially manufacturing SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis 7 intensive—more than 20 percent of all employees in these counties work for manufacturing firms. Nonmetropolitan counties in the northern states of the District, particularly Missouri, Illinois and Kentucky, generally have average or below average shares of manufacturing employment. What, then, explains the north/ south discrepancy in the District’s manufacturing employment concentrations? For the most part, it exists because southern states generally District norm. Only in Mississippi and Tennessee did rural per capita income grow faster than urban. By the mid-1980s, growth in per capita income accelerated in nearly all District states—in some cases by almost one percentage point a year. However, very few District counties experienced income growth of more than 3 percent a year during the period—only 6 percent of all rural counties, mostly in the southern states, and no urban counties. Even fewer MANUFACTURING EMPLOYMENT’S SHARE OF TOTAL EMPLOYMENT-1994 Metropolitan Nonmetropolitan SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis have less restrictive labor laws and lower labor costs than their northern neighbors. In fact, average manufacturing wages in southern District states are about $3 an hour less than in northern District states. This has made southern states particularly attractive to firms looking to cut costs and improve efficiency, as increasingly fierce competition has evolved in domestic and foreign markets. What about Income Growth? Another measure of a region’s prosperity is its personal income growth. Per capita personal income measures the average level of income per person. Between 1974 and 1984, real per capita income (adjusted for inflation) in the District grew slightly less than 1 percent a year. The Rust Belt states exhibited the slowest growth, while increases in Arkansas, Missouri and Tennessee exceeded the 8 had declines in income. Thus, just about all counties experienced average growth, regardless of whether they were rural or urban. A clear urban/rural distinction exists in the level of per capita income among District counties, though. Metropolitan counties are, for the most part, wealthy; nonmetropolitan counties, particularly those in the southern states, are mostly poor. As a result, rural areas still have problems they haven’t yet overcome, which, if not addressed, will restrain their prospects for future growth. The income disparity with their urban neighbors, and its resultant poverty, is one of their most prevalent problems. Prevalent Poverty District rural counties, especially in the south, have the region’s highest concentrations of poor people. Regional Economist January 1997 In fact, about 40 percent of these counties had more than 21 percent of their populations living below the poverty line in 1989.6 In contrast, most District metropolitan counties had less than 14 percent of their populations living below the poverty line. Given the amount of poverty that exists in District rural counties, and the fast income growth experienced by some of these counties in the late 1980s and early 1990s, one might suspect that increases in government payments to the poor may have driven some of the growth. In fact, they did. Between 1984 and 1994, per capita government payments, adjusted for inflation, grew about half a percentage point a year faster in each state’s rural areas than in its urban areas. A Bit Older and Wealthier Certainly, though, these payments were not all going to those in poverty. In 1994, only 11 percent of all federal government transfer payments went to welfare programs, while 70 percent went to Social Security and Medicare. Perhaps, then, most of these transfer payments were not going to those in poverty, but rather to those receiving Social Security and Medicare. The evidence supports this. The rural areas of all seven District states have a larger share (15 percent) of their population in the 65 and older age group than their urban neighbors (12 percent). Although this pattern holds true for each District state, it is most pronounced in Arkansas, Illinois and Missouri. Rural regions likely benefit from the larger presence of this age group because its members not only receive a steady stream of income and services from the government, but they also have accumulated wealth, which they’re willing to spend. As a matter of fact, a recent economic study found that the Social Security and Medicare programs, for example, have enabled senior citizens to spend savings that otherwise would have been kept for medical emergencies or other necessities.7 This has allowed them to become some of the biggest spenders in the economy today, which probably bodes well for the future of rural areas. as, or better than, their urban neighbors. Although some of the growth could be a spillover from urban revitalization projects, many rural areas have exhibited income growth that’s at least comparable to, and employment growth that’s stronger than, their urban counterparts. Moreover, rural areas have diversified their economies away from agriculture, which represents just a minuscule portion of total output today. Manufacturing is one sector that has been instrumental in this diversification. Nonmetropolitan counties are now some of the District’s most manufacturing-intensive areas. Large pools of labor and better access to transportation have helped rural regions attract these businesses away from cities. The next wave of development will likely arise from pathbreaking telecommunications technologies. A recent General Accounting Office report argues that while improved roads were once seen as the key to “rural areas’ overcoming the barrier of distance, . . .telecommunications technologies may [now] be a critical element in many rural areas’ efforts to maintain and foster social and economic development.”8 The belief is that these technologies will better link rural areas with other communities and their expertise, thereby improving medical services, creating new jobs and increasing access to educational opportunities. Because firms that specialize in information technology and services, which will probably lead the economy in future growth opportunities, can essentially locate themselves anywhere, lower-cost areas will be the most attractive. If per capita income continues to grow as it has for the past 10 years, then rural areas, especially in the southern parts of the District where business costs are lower, can expect to see even more development than they have already. Adam M. Zaretsky is an economist at the Federal Reserve Bank of St. Louis. Eran Segev provided research assistance. ENDNOTES 1 The terms “urban” and “metropolitan,” and “rural” and “nonmetropolitan” are not strictly synonymous; however, they will be used interchangeably in this article. “Metropolitan areas” refer to metropolitan statistical areas and consolidated metropolitan statistical areas, as defined by the U.S. Office of Management and Budget. 2 See Zaretsky (1994) for a more detailed description of these incentives. 3 See Cooper and Sigalla (1996) for a description of how technological advances have made agriculture more productive and efficient. 4 The region includes Arkansas, Illinois, Indiana, Kentucky, Mississippi, Missouri and Tennessee. Although the Eighth Federal Reserve District does not cover all of these states in their entirety, this article will refer to whole states in its analysis. 5 Farm employment, which is not included in payroll employment data, declined in all areas during 1974-1984 and 1984-1994. It represents a very small fraction of total employment, however. 6 The cutoff of 21 percent is used because one-third of District counties had more than this share of their populations living in poverty in 1989. 7 See Gokhale and others (1996). 8 See U.S. General Accounting Office (1996), p. 1. REFERENCES Cooper, J.B., and Fiona Sigalla. Agriculture, Technology and the Economy, Federal Reserve Bank of Dallas (Fall 1996). Drabenstott, Mark, and Tim R. Smith. “The Changing Economy of the Rural Heartland.” Economic Forces Shaping the Rural Heartland, Federal Reserve Bank of Kansas City (April 1996), pp. 1-11. Gokhale, Jagadeesh, Laurence J. Kotlikoff, and John Sabelhaus. “Understanding the Postwar Decline in U.S. Saving: A Cohort Analysis.” Brookings Papers on Economic Activity, no. 1 (1996), pp. 315-407. Morgan, Kathleen O’Leary, Scott Morgan, and Neal Quinto. State Rankings 1996: A Statistical View of the 50 United States, 7th ed. Morgan Quinto Press (1996). Smith, Tim R. “Determinants of Rural Growth: Winners and Losers in the 1980s,” Research working paper, RWP 92-11, Federal Reserve Bank of Kansas City (December 1992). U.S. General Accounting Office. Rural Development: Steps Toward Realizing the Potential of Telecommunications Technologies, GAO/RCED-96-155 (June 1996). Zaretsky, Adam M. “Are States Giving Away the Store?” The Regional Economist, Federal Reserve Bank of St. Louis (January 1994), pp. 5-9. What’s in Store for These Regions? Despite popular misconceptions, District rural areas have not been left behind over the past two decades. In fact, they have generally fared as well 9 by Miche lle Cla rk Nee ly T aking a cue from Canada, the United Kingdom and other countries, the U.S. Treasury decided last year to begin offering inflation-indexed bonds to investors looking to protect their savings from unexpected increases in inflation. With the first auction scheduled for early 1997, economists, finance professionals and policymakers are cheering the change. But will indexed bonds shake the market, or merely cause a stir? What’s An Indexed Bond? Unlike a conventional, or nominal bond, an inflationindexed, or real, bond promises to pay its holder a fixed real rate of return—a return that is unaffected by unexpected changes in the inflation rate. While a conventional bond repays an investor principal plus some stated interest, an indexed bond repays principal adjusted for inflation and a fixed interest rate applied to the adjusted principal. Investors value such protection because large increases in unanticipated inflation can eat away at an investment’s real return. Expected inflation, real returns and nominal returns are linked by a simple relationship called the Fisher equation, which states that the real return on a bond is roughly equivalent to the nominal interest rate minus the expected inflation rate.1 For example, if an investor purchases a Treasury security with a 6 percent nominal interest rate, and inflation is expected to be zero during the investment period, the real expected return would be 6 percent. In the real world, however, inflation is usually positive, so in most cases the real rate of return will be less than the nominal return. Because investors understand this relationship between inflation and real returns and want, therefore, to be compensated for any decline in purchasing power, nominal interest rates tend to rise when investors expect the inflation rate to worsen, and vice versa. But what happens if actual inflation is higher than expected inflation? An investor purchasing a conventional bond at 7 percent expects a real return of 5 percent if inflation is expected to be 2 percent during the investment period. If actual inflation turns out to be 4 percent, however, the bond’s real return drops to 3 percent. If the actual inflation rate is high enough, the real return can even turn negative, causing the investor to pay the borrower for the privilege of using his money, rather than the other way around. An inflation risk premium is built into nominal bond yields to compensate investors for the risk that inflation will be higher than expected. Of 10 course, inflation risk can work the other way: If actual inflation is less than expected inflation, the investor gains while the issuer loses. Because investors are thought to be risk averse—they dislike surprise losses more than they like surprise gains of equal magnitude—the inflation risk premium in nominal interest rates is positive. Indexed bonds eliminate inflation uncertainty. A holder of an indexed bond is assured that the real cash flow of the bond (principal plus interest) will not be affected by inflation. On the surface, at least, indexing appears to be a win-win proposition. Investors gain because their capital is protected, while issuers gain because they do not have to pay the inflation risk premium. Moreover, this joint gain increases with the term of the bond, for two reasons. First, there is a higher risk that expected inflation will differ from actual inflation the further out into the future you go, and second, any inflation forecast error is magnified with longer-term bonds because of interest compounding. The Treasury Experiment Although the Treasury’s initial auction of inflation-indexed bonds is to be for 10-year notes starting at $1,000 denominations, by early 1998, the Department plans to offer indexed securities of other maturities, as well as indexed savings bonds.2 The 10-year indexed notes will be auctioned quarterly in a uniform price auction similar to that used for other marketable Treasury securities. The Treasury’s indexed bond is structured like the Canadian real return bond. The Department will calculate semi-annual interest payments by adjusting the principal for inflation and applying the auctiondetermined, fixed real interest rate to the adjusted principal. The inflation adjustment will be based on the Consumer Price Index for all Urban Consumers (CPI-U), a widely used, though flawed, measure of U.S. inflation.3 To ensure that investors will not come up short from any deflation occurring during the investment period, the Treasury has promised that the final principal payment will be at least equal to the original par amount of the security at issuance.4 Indexed Bond Benefits Investors, issuers and policymakers— especially monetary policymakers— Regional Economist January 1997 all stand to gain from indexed bonds. For investors, the major benefit is the guarantee of a real yield.5 In the past, government bond investors have been burned when inflation exceeded nominal interest rates, resulting in negative real returns. Although the inflation rate has been relatively low for the past several years—hovering around 3 percent—there is always a chance that poor economic policy or an external shock could drive it higher. Consequently, the Treasury Department is promoting the securities to conservative investors who can ill-afford capital losses, like those saving for impending retirement or college costs and those living on fixed incomes. The potential benefits for the Treasury are many. Indexed bonds could substantially reduce inflation risk and—depending on their share of total government debt—stabilize the Treasury’s real funding costs. While unexpectedly high inflation benefits the Treasury by lowering the real return it has to pay investors, unexpectedly low inflation increases the government’s funding costs. For example, the Treasury is currently paying a 15.75 percent coupon on a 20-year bond it issued in 1981 when CPI-U inflation was 10.4 percent; the real cost to the Treasury for that bond at issuance was 5.35 percent. Today, however, with inflation averaging about 3 percent, the real cost of the bond is close to 13 percent. Many analysts believe the Treasury will pay real rates of 3 percent to 4 percent on long-term indexed bonds. The more certain benefit for the Treasury is the money it will save by eliminating the inflation risk premium on some portion of its debt. Although the size of the premium is debatable, most economists estimate it to be at least 50 basis points for short-term bonds and even more for longer-term bonds.6 Because the Treasury borrows about $200 billion a year, the potential savings could be substantial, even if just a small portion of new debt were indexed. One of the subtler, yet equally important, benefits brought about by indexing government debt is the information the process would provide policymakers about inflation expectations and real interest rates. For their part, monetary policymakers could ascertain a market-based estimate of inflation expectations by observing the difference in interest rates on conventional and indexed bonds of the same maturities. They could then use these estimates to assess how well the central bank is doing its job. Demand Downside Despite these wide-reaching benefits, the success of indexed bonds is by no means certain. Demand for them will be dampened by several factors, not the least of which is the tax treatment they are subject to. The tax consequences are twofold. First, because the current U.S. tax code does not distinguish between increases in real income and increases in nominal income due to inflation, the indexed bond holder’s tax liabilities will increase, lowering the after-tax real yields on these securities. Second, the Treasury has determined that investors will pay taxes on the inflation-adjusted increase in principal accrued each year (as well as the interest received), even though it is not paid out to maturity. A surge in inflation, therefore, could result in a tax liability that would swamp the current cash income from the bond. Because of this unfavorable tax treatment, many analysts think the demand for these securities will be limited to tax-deferred financial assets, like IRAs and 401(k) plans. Another factor working against the success of indexed bonds is that, even after adjusting for inflation and risk, they still will be outperformed by stocks and many corporate bonds, especially over the long term. That’s why they’re likely to make up only a small portion of most investors’ portfolios. But even if inflation-indexed bonds fail to dazzle the securities world, they’re still likely to quench the thirst of conservative investors— without leaving them on the rocks. Michelle Clark Neely is an economist at the Federal Reserve Bank of St. Louis. Thomas A. Pollmann provided research assistance. 11 ENDNOTES 1 This relationship assumes there is no default or interest rate risk premiums. 2 Treasury securities with original maturities ranging from one to 10 years are notes; securities with original maturities of greater than 10 years are bonds. The term “bond” will be used hereafter to refer to either or both. 3 See Berry and Pianin (1996) for information about biases in the CPI. 4 See the Federal Register (1996) for more detail on the structure of these bonds. 5 Indexed bond holders are not, however, immune from market risk (the risk that the price of an already-issued security will decline in response to increases in market interest rates) if they sell before maturity. That said, most analysts believe that inflation protection will reduce market risk. 6 See Campbell and Shiller (1996) for a discussion of estimates of the size of the inflation risk premium. FOR FURTHER READING Berry, John M., and Eric Pianin. “Hill Panel Says Inflation Overstated,” Washington Post (December 5, 1996). Campbell, John Y., and Robert J. Shiller. “A Scorecard for Indexed Government Debt,” National Bureau of Economic Research Working Paper No. 5587 (April 1996). Federal Register, U.S. Department of the Treasury. 31 CFR Part 356. “Sale and Issue of Marketable Book-Entry Treasury Bills, Notes, and Bonds (Department of the Treasury Circular, Public Debt Series No. 1-93); Proposed Rule (September 27, 1996). Hetzel, Robert L. “Indexed Bonds as an Aid to Monetary Policy,” Economic Review, Federal Reserve Bank of Richmond (January/ February 1992), pp. 13-23. Shen, Pu. “Benefits and Limitations of Inflation Indexed Treasury Bonds,” Economic Review, Federal Reserve Bank of Kansas City (Third Quarter 1995), pp. 41-56. weather-related development, national trends in farm income typically hold at the state level as well. District Farmers Cash In In the upper reaches of the Eighth Federal Reserve District, corn and soybeans reign as the dominant crops, while in the southern parts, cotton and rice are king.2 The District is also home to a significant portion of the nation’s production of broilers (in Arkansas) and catfish (in Mississippi). To understand why crop receipts and the value of farm inventories contributed so heavily to the rise of real NFI in 1996, it’s helpful to look at how the corn, cotton, rice and soybean harvests fared in the District and the United States last year. As the accompanying figure indicates, with the exception of rice, production of the four crops in the seven District states in 1996 surpassed that in 1995. In the case of corn and soybeans, substantially more output was produced last year, while in the case of cotton, only a modest increase in production was seen.3 What’ s Up Down on the Farm? by Kevin L. Kliesen N ineteen ninety-six was a pretty good year for farmers in the Eighth Federal Reserve District. Above-average prices and higher-than-normal crop yields in the past year are expected to produce a substantial rebound in aggregate farm income. These increases also bode well for rural businesses—like automobile and farm machinery dealers— which expect farmers to spend a good part of their increased fortunes on Main Street. 1996 Farm Income: Lots of “Spendin’ Cabbage” The most commonly cited measure of farm income is the United States Department of Agriculture’s (USDA) net farm income series. Net farm income (NFI) is the sum of crop and livestock receipts, government farm program payments, noncash income (such as the value of food grown on the farm for home consumption) and other miscellaneous farm-related income, less production expenses (including labor and property taxes), a capital consumption allowance (depreciation) and taxes and interest on real estate. Net farm income also includes the value of the change in farm inventories, which is the difference between the value of farm inventories at the beginning and end of the year. By this measure, the USDA projects real farm income to be $46.2 billion in 1996, more than 43 percent above that registered in 1995, and more than 8 percent above its 1990-95 average.1 The USDA expects most of the rise in real 1996 NFI to come from a $6.3 billion increase in the value of farm inventories and a $6.0 billion increase in crop receipts. A further boost to farm income is expected from the sales of livestock and related products, which are predicted to increase $3.4 billion in 1996. Overall, this jump in farm incomes reflects the effects of both higher prices and increased production. On the price side, through the first three quarters of 1996, the USDA’s index of aggregate crop prices was at its highest level since the series began in 1975. Similarly, the index of livestock prices in the third quarter of 1996 was at its highest in six years. On the output side, total meat production through the first 10 months of 1996 was up a little more than 2.5 percent from the same period in 1995, while the fall harvest was generally bountiful, produced bin-busting crops. Although corresponding state level data will not be available until late 1997 at the earliest, unless a state suffers from an unusual 12 Corn As the figure shows, corn production in the District last year was a little more than a third larger than the crop harvested in 1995. The two largest corn-producing states—Illinois and Indiana—saw increases of 31 and 13 percent, respectively, while Missouri’s production more than doubled, and Arkansas’ harvest nearly doubled. The uptick in production occurred because harvested acreage increased in all seven states and— except for Arkansas and Tennessee— yields were also higher in 1996 than in 1995. At 9.3 billion bushels, the national 1996 corn crop was the third largest on record. This surpassed the 1995 crop by more than 25 percent, but fell about 8 percent short of the 1994 record. Normally, a surge in production of this magnitude would push corn prices down significantly. However, because the supply of U.S. corn ended the 1995/96 marketing year at its lowest level in more than two decades, the increased production is expected to keep 1996/97 ending stocks (inventories) about 23 percent below their 1990-95 average. As a result, the average price of corn for the 1996/97 marketing year is expected to be about $2.70 a bushel, which is much higher than the $2.30 average that prevailed from 1990 to 1995, but still well below the $3.24 average for 1995/96. Regional Economist January 1997 Cotton Four states in the Eighth District— Arkansas, Mississippi, Missouri and Tennessee—accounted for onequarter of the U.S. cotton crop last year, which, at an estimated 18.6 million bales, was the third largest on record. Despite the fact that nearly 11 percent fewer acres were harvested in Arkansas last year and 27.5 percent fewer were harvested in Mississippi, the four-state production total was still 2.3 percent larger than in 1995. A large jump in cotton yields is credited for the increase, with the average four-state yield more than 25 percent above the 1995 average. In fact, the 1996 U.S. cotton crop was the fourth highestyielding on record. Strong domestic demand by textile producers is expected to keep cotton prices in the 1996/97 marketing year about 7.5 cents a pound higher than the 64.5-cent average from 1990-96. Rice U.S. rice production is heavily influenced by Arkansas, which regularly ranks as the nation’s largest producer, and, to a lesser extent, Mississippi. Combined, the states account for almost half of U.S. production; adding in Missouri’s crop pushes the District share to 52.5 percent. Last year’s production in the Eighth District was down 3.4 percent from 1995. Accordingly, the U.S. rice crop increased just 0.1 percent from 1995. Although Arkansas farmers harvested 7.5 percent fewer acres, their rice crop last year was up 0.2 percent from 1995, as yields surpassed the all-time record set in 1994. In Mississippi, the number of harvested acres dropped by almost a quarter, and, although yields rose by more than 9 percent, total production fell by slightly more than 17 percent. Missouri’s rice crop dropped by a little more than 11.5 percent, with both yields and harvested acres below those seen in 1995. The drop in District rice production stemmed from fewer acres being planted in the spring, as many farmers—particularly in Mississippi—planted corn instead to take advantage of the high prices that prevailed at the time. With 1996 U.S. rice production little changed from 1995, and domestic use in the current (1996/97) marketing year expected to be only modestly above the five-year average, ending rice stocks in 1996/97 are projected to fall to a near all-time low of 25.6 million hundredweight.4 As a result, the USDA projects rice prices to average 92.5 cents a pound in the current marketing year, up a little more than a penny a pound from the year before, and the highest average price received by farmers since 1980/81. ENDNOTES Soybeans The 1996 District soybean crop was a little more than 12 percent larger than the 1995 one. In Illinois and Indiana, the two largest-producing states of the seven, last year’s crop was up more than 6 percent. By contrast, in Missouri and Arkansas, the 1996 soybean crop increased by 19 percent and 30.3 percent, respectively. Except for Missouri and Tennessee, 1996 harvested acres in the District exceeded those from 1995, while yields were generally little changed from the previous year. Estimated at 2.4 billion bushels, the 1996 U.S. soybean crop was the second largest on record, surpassed only by the 2.5-billion bushel 1994 crop. Nevertheless, in the current marketing year ending stocks—which fell to a seven-year low in 1995/96— are still expected to end up well below the 1990/95 average. Thus, the USDA projects that soybean prices in 1996/ 97 will average about $6.50 a bushel, down only modestly from the sevenyear high posted in the previous year, but still well above the $5.92 average from the 1990-96 period. Overall, 1996 was a memorable one for Eighth District farmers. With crop inventories generally well below their five-year average, it appears that farm prices will stay at relatively high levels this marketing year. Coupled with the bumper harvests yielded by many crops, real farm incomes in 1996 should greatly exceed those logged during the previous year. Kevin L. Kliesen is an economist at the Federal Reserve Bank of St. Louis. Daniel R. Steiner provided research assistance. 13 1 Forecasts of farm income for 1996 are preliminary estimates only. USDA farm income forecasts are originally expressed in currentdollar (nominal) terms. In this article, they have been inflationadjusted using the gross domestic product (GDP) price index. See USDA (1996). 2 The seven-state area comprises all of Arkansas and parts of Illinois, Indiana, Kentucky, Mississippi, Missouri and Tennessee. See back cover. 3 Estimates of 1996 production, yields, acres harvested, ending stocks and average prices received by farmers come from the USDA’s Crop Production Report and the World Agriculture Supply and Demand Estimates, both of which were released in November of 1996. Analysis of corn, cotton, rice and soybeans typically refers to marketing years rather than calendar years. Marketing years for corn and soybeans begin on Sept. 1 and end on Aug. 31 of the subsequent year. The marketing year for cotton and rice runs from Aug. 1 to July 31. Forecasted prices for 1996/97 refer to the USDA’s midpoint estimate of marketing year average price. 4 A hundredweight is a unit of measurement for rice consisting of 100 pounds. REFERENCES United States Department of Agriculture. Crop Production, National Agricultural Statistics Service, November 12, 1996. United States Department of Agriculture. World Agriculture Supply and Demand Estimates, World Agricultural Outlook Board, November 12, 1996. Pieces Eight News bulletins from the Eighth Federal Reserve District Open-Door Policy sibilities in formulating monetary policy, providing financial services, and supervising and regulating financial institutions. Visitors are also privy to upclose views of the Bank’s Protection and Cash departments, including the vault. The Bank’s core tour program will continue to operate as usual, offering tours to groups of 10 to 42 persons, high school age and older, at 9:30 a.m. and 1:30 p.m., Monday through Friday. For more information on either type of tour, contact Tammy Stutes at (314) 444-8560. For years, the St. Louis Fed has given tours of its facility to educational and employee groups interested in obtaining a first-hand view of one of the country’s 12 Reserve Banks. Starting in 1997, the tour program has expanded to accommodate families, vacationers and other “non-group” visitors, too. “Walk-in” tours are now available at 11 a.m. on Fridays, starting in the Bank’s main lobby, which is at 411 Locust St. The 45-minute presentation outlines the Fed’s respon- NET Sports New Look in ’97 G ood news for data junkies: National Economic Trends, the St. Louis Fed publication that provides a comprehensive wide data, it now concentrates on graphical presentation of the data. and can be ordered by calling (314) 444- The changes, says Fed economist and pub- 8808. NET and the underlying data are also lication editor Joe Ritter, should make the data available electronically through the St. Louis Fed’s home page at www.stls.frb.org. monthly briefing on the state of the U. S. more digestible and ease comparisons across economy, has been redesigned to include time and between series. The publication also even more data and better comparisons. now includes greater cover- While the publication still reports, rather than analyzes, monthly and quarterly nation- Single-copy subscriptions to NET are free age of asset markets and Economical Education international trade. District State Colleges Cost Less Banking Data at Your Fingertips District State Just about anything you’d ever want to know about a U.S. bank or thrift is now available online through the FDIC’s new “Institution Directory System.” The system contains financial and demographic information on more than 12,000 banks and thrifts. Quarterly financial statistics available on the site include: earnings, deposit and loan data, and loan quality measures like charge-offs. The financial data are available for the last three years, enabling a user to look at a bank’s financial performance relative to previous years. The system can be found by clicking on “Data Bank” and then “Institution Directory” on the FDIC’s home page (www.fdic.gov). Illinois Indiana Missouri Kentucky Mississippi Tennessee Arkansas 14 Rank Among 50 States 1996 State College Costs1 16 18 24 40 42 44 48 $7,829 7,392 6,750 5,455 5,425 5,372 5,064 National Average 1 $7,013 Average undergraduate tuition and fees and room and board at public colleges and universities SOURCE: U.S. Department of Education Regional Economist January 1997 District Data Selected economic indicators of banking, agricultural and business conditions in the Eighth Federal Reserve District Commercial Bank Performance Ratios U.S., District and State All U.S. U.S. District <$15B 1 AR IL IN KY MS MO TN Return on Average Assets (Annualized) 3rd quarter 1996 1.24% 1.33% 1.31% 1.35% 1.03% 1.29% 1.26% 1.50% 1.32% 1.45% 2nd quarter 1996 1.21 1.33 1.29 1.31 1.02 1.30 1.19 1.50 1.34 1.40 3rd quarter 1995 1.21 1.34 1.30 1.28 1.17 1.28 1.22 1.46 1.31 1.45 Return on Average Equity (Annualized) 3rd quarter 1996 15.25% 14.68% 14.81% 14.11% 10.22% 14.23% 14.37% 15.64% 15.90% 17.34% 2nd quarter 1996 14.99 14.76 14.58 13.78 10.05 14.25 13.58 15.72 16.09 16.89 3rd quarter 1995 15.22 15.28 14.87 13.75 11.85 13.90 14.05 15.98 16.03 17.83 Net Interest Margin (Annualized) 3rd quarter 1996 4.38% 4.81% 4.39% 4.51% 4.23% 4.41% 4.53% 4.97% 4.15% 4.41% 2nd quarter 1996 4.27 4.77 4.33 4.43 4.22 4.37 4.35 4.93 4.15 4.36 4.23 4.81 4.33 4.30 4.46 4.58 4.25 5.09 4.18 4.23 3rd quarter 1996 1.10% 1.11% 0.78% 0.81% 1.15% 0.71% 0.74% 0.73% 0.72% 0.77% 2nd quarter 1996 1.12 1.10 0.81 0.80 1.09 0.69 0.87 0.74 0.78 0.72 3rd quarter 1995 1.23 1.10 0.71 0.68 1.01 0.56 0.82 0.64 0.61 0.66 3rd quarter 1996 0.57% 0.71% 0.31% 0.20% 0.39% 0.23% 0.39% 0.29% 0.27% 0.40% 2nd quarter 1996 0.57 0.70 0.31 0.19 0.34 0.20 0.41 0.28 0.29 0.36 3rd quarter 1995 0.45 0.53 0.21 0.13 0.39 0.15 0.29 0.23 0.12 0.25 3rd quarter 1996 1.96% 1.84% 1.51% 1.34% 1.56% 1.35% 1.51% 1.54% 1.62% 1.50% 2nd quarter 1996 1.99 1.89 1.53 1.34 1.62 1.36 1.53 1.58 1.63 1.49 3rd quarter 1995 2.07 1.91 1.56 1.34 1.54 1.39 1.57 1.62 1.70 1.55 3rd quarter 1995 Nonperforming Loans 2 ÷ Total Loans Net Loan Losses ÷ Average Total Loans (Annualized) Loan Loss Reserve ÷ Total Loans NOTE: Data include only that por tion of the state within Eighth District boundaries. 1 U.S. banks with average assets of less than $15 billion are shown separately to make comparisons with District banks more meaningful, as there are no District banks with average assets greater than $15 billion. 2 Includes loans 90 days or more past due and nonaccrual loans SOURCE: FFIEC Reports of Condition and Income for Insured Commercial Banks 15 Commercial Bank Performance Ratios by Asset Size 3rd Quarter 1996 Earnings Asset Quality Return on Average Assets Net Loan Loss Ratio Percent Percent Annualized Nonperforming Loan Ratio Percent Percent Percent Annualized 3 2 Loan Loss Reserve Ratio 3 Annualized Percent D = District < $100 Million $300 Million – $1 Billion US = United States $100 Million – $300 Million $1 Billion – $15 Billion NOTE: Asset quality ratios are calculated as a percent of total loans. 1 Annualized Return on Average Equity Net Interest Margin 2 1 Loan losses are adjusted for recoveries Includes loans 90 days or more past due and nonaccrual loans Interest income less interest expense as a percent of average earning assets SOURCE: FFIEC Reports of Condition and Income for Insured Commercial Banks 16 Regional Economist January 1997 Agricultural Bank Performance Ratios U.S. Return on average assets (annualized) 3rd quarter 1996 2nd quarter 1996 3rd quarter 1995 Return on average equity (annualized) 3rd quarter 1996 2nd quarter 1996 3rd quarter 1995 Net interest margin (annualized) 3rd quarter 1996 2nd quarter 1996 3rd quarter 1995 Ag loan losses ÷ average ag loans (annualized) 3rd quarter 1996 2nd quarter 1996 3rd quarter 1995 Ag nonperforming loans 1 ÷ total ag loans 3rd quarter 1996 2nd quarter 1996 3rd quarter 1995 AR IL IN KY MS MO TN 1.30% 1.27 1.28 1.44% 1.40 1.30 1.25% 1.24 1.28 1.31% 1.32 1.26 1.49% 1.47 1.49 1.66% 1.63 1.71 1.33% 1.31 1.28 1.40% 1.40 1.22 12.67% 12.38 12.37 13.34% 12.99 12.38 11.43% 11.34 11.76 14.08% 13.61 12.78 14.37% 14.24 14.72 18.06% 17.79 19.11 12.90% 12.78 12.50 13.27% 13.22 12.79 4.54% 4.48 4.59 4.40% 4.39 4.36 4.14% 4.09 4.26 4.55% 4.55 4.70 4.62% 4.58 4.67 5.32% 5.27 5.50 4.52% 4.47 4.42 4.55% 4.52 4.37 0.29% 0.28 0.17 0.07% 0.06 -0.01 0.14% 0.19 -0.01 0.12% -0.15 0.07 0.24% 0.18 0.19 0.79% 1.37 0.26 0.32% 0.30 -0.04 0.23% 0.29 0.08 1.63% 1.92 1.29 0.54% 0.74 0.29 1.09% 0.97 1.26 2.22% 1.99 0.29 1.26% 2.01 1.36 1.87% 3.10 0.88 0.85% 1.25 1.00 0.04% 0.44 0.35 NOTE: Agricultural banks are defined as those banks with a greater than average share of agricultural loans to total loans. Data include only that portion of the state within Eighth District boundaries. 1 Includes loans 90 days or more past due and nonaccrual loans SOURCE: FFIEC Reports of Condition and Income for Insured Commercial Banks U.S. Agricultural Exports by Commodity U.S. Crop and Livestock Prices Dollar amounts in billions Commodity Jul Aug Sep Livestock & products .83 .90 .82 Year-to-date 10.95% Change from year ago 7.0% Corn .70 .52 .44 8.37 26.0 Cotton .73 1.00 .07 3.03 -13.0 Rice .07 .72 .09 1.00 -4.0 Soybeans .37 .43 .35 6.31 20.0 Tobacco .05 .09 .09 1.39 5.0 Wheat .62 .79 .66 6.88 39.0 TOTAL 4.46 4.63 4.38 59.76 10.0 Indexes of Food and Agricultural Prices Growth 1 Level Prices received by U.S. farmers 2 Prices received by District farmers3 Arkansas Illinois Indiana Missouri Tennessee Prices paid by U.S. farmers Production items Other items Consumer food prices Consumer nonfood prices III/96 II/96 III/95 II/96-III/96 III/95-III/96 117 112 103 16.3% 13.6% 143 144 145 119 143 136 136 146 110 138 126 104 106 102 131 22.2 25.8 -1.8 38.6 13.1 13.8 38.6 36.4 16.7 8.9 116 115 154 158 115 115 152 157 109 110 149 154 4.7 1.2 5.6 1.6 6.4 4.5 3.6 2.8 NOTE: Data not seasonally adjusted except for consumer food prices and nonfood prices. 1 Compounded annual rates of change are computed from unrounded data. 2 Index of prices received for all farm products and prices paid (1990-92=100) 3 Indexes for Kentucky and Mississippi are unavailable. 17 Selected U.S. and State Business Indicators Compounded Annual Rates of Change in Nonagricultural Employment United States III/1996 II/1996 III/1995 Labor force 134,135 133,647 132,380 (in thousands) Total nonagricultural employment 119,947 119,264 117,441 (in thousands) 5.2% 5.4% 5.6% Unemployment rate II/1996 I/1996 II/1995 Real personal income* (in billions) $4,082.4 $4,054.9 $3,980.4 Arkansas III/1996 II/1996 III/1995 Labor force 1,245.9 (in thousands) Total nonagricultural employment 1,088.8 (in thousands) 5.3% Unemployment rate 1,082.4 1,072.4 4.8% 5.0% II/1996 I/1996 II/1995 Real personal income* (in billions) $30.2 1,234.0 1,225.7 $29.8 $29.4 Illinois III/1996 II/1996 III/1995 Labor force 6,155.2 (in thousands) Total nonagricultural employment 5,706.1 (in thousands) 5.4% Unemployment rate II/1996 Real personal income* (in billions) $199.2 6,149.3 6,086.4 5,687.6 5,617.6 5.2% 5.2% I/1996 II/1995 $198.5 $194.6 Indiana III/1996 II/1996 III/1995 Labor force 3,093.1 (in thousands) Total nonagricultural employment 2,788.9 (in thousands) 4.2% Unemployment rate II/1996 Real personal income* (in billions) $82.5 3,096.3 3,129.1 2,799.1 2,772.2 4.2% 4.6% I/1996 II/1995 $82.0 $81.4 18 Regional Economist January 1997 Kentucky III/1996 II/1996 III/1995 Labor force 1,861.7 (in thousands) Total nonagricultural employment 1,672.6 (in thousands) 4.7% Unemployment rate II/1996 Real personal income* (in billions) $48.9 1,829.0 1,860.5 1,671.1 1,643.4 5.2% 5.5% I/1996 II/1995 $48.3 $47.6 Mississippi III/1996 II/1996 III/1995 Labor force 1,263.5 (in thousands) Total nonagricultural employment 1,075.8 (in thousands) 5.8% Unemployment rate 1,080.9 1,078.5 6.1% 6.4% II/1996 I/1996 II/1995 Real personal income* (in billions) $29.9 1,266.4 1,262.6 $29.8 $29.3 Missouri III/1996 II/1996 III/1995 Labor force 2,851.5 (in thousands) Total nonagricultural employment 2,559.3 (in thousands) 4.1% Unemployment rate 2,559.2 2,524.6 4.3% 4.9% II/1996 I/1996 II/1995 Real personal income* (in billions) $77.3 2,847.0 2,850.3 $77.1 $75.9 Tennessee III/1996 II/1996 III/1995 Labor force 2,756.2 (in thousands) Total nonagricultural employment 2,564.2 (in thousands) 4.6% Unemployment rate 2,554.1 2,507.2 4.8% 5.5% II/1996 I/1996 II/1995 Real personal income* $73.1 (in billions) Total Manufacturing 2,747.8 2,717.6 $72.9 $72.1 Construction Government General Services Finance, Insurance and Real Estate Transportation, Communication and Public Utilities Wholesale/Retail Trade NOTE: All data are seasonally adjusted. The nonagricultural employment data reflect the 1995 benchmark revision. * Annual rate. Data deflated by CPI, 1982-84=100. 19
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