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Why Farmland Can Be An Effective Inflation Hedge

The economic theory behind monetary inflation is simple, by increasing the number of currency units in an economy well beyond its growth rate, the "nominal" price for physical assets must then adjust higher to compensate. The major reserve banks of the world have increased their respective money supplies way beyond the normal needs of their weak economies and way beyond anything ever seen before in advanced countries. The common reasoning why monetary inflation has not become a problem yet is because all the money has not flowed through the system. It sits on the bank's balance sheets for many well understood reasons: (1) banks are retrenching to allow time for their financial position and quality of loans to improve; (2) the public is dealing with underwater mortgages and high unemployment; (3) and corporations have plenty of cash and are wary of expanding. It will take a long time, but once enough bank and private debt is paid off or defaulted on, things will begin to get going again. Money will start to flow and monetary inflation could easily be a huge factor. Federal Reserve bankers seem sure they can remove these piles of recently printed cash before it gets sucked into the system to inflate prices. That is hard to imagine though when considering how big the increase in money supply has really been.

Let's say they were able to remove this liquidity quickly, this would require aggressive actions by the reserve banks and would surely snuff out any nascent recovery in short order. Well aware of this, the Fed's of the world are going to lean towards less removing liquidity and more time for growth to take hold, which would then increase the risk of high levels of monetary inflation (Bernanke has already clearly said he will error to the side of growth before beginning to remove the expansionist measures). The depth of this current recession is severe enough that anything close to strong growth levels is many months if not years away. Nevertheless, it is prudent to hold investments now that are likely to be very good hedges against inflation rather than wait (especially ones with cash flow). Monetary inflation will probably come without warning and so fast it will be hard to act.

This brings us to farmland and whether it is a viable inflation hedge. The answer I suggest is yes, in fact, it may be one the best choices. Food and fuel inflation have already been having a bullish effect on farmland, extreme monetary inflation would carry an even bigger impact. Historically, farmland prices have statistically shown a high correlation with inflation, much more consistent than even gold. I compared the USDA's statistics for U.S. farmland prices, using the average change for Iowa, Indiana and Illinois since 1971, with the annual change in the CPI as the measure of inflation. There was a significant correlation (0.43) between farmland prices and the CPI, confirming what a number of other academic studies have found - that farmland has been a viable inflation hedge. The following table shows during periods of high inflation farmland has responded with even higher price gains.

Since 1971, during the years when inflation was:

Farmland Prices Returned on average during those years:

Over 3%

 

+ 8.3%

Over 4%

 

+ 12.3%

Over 6%

 

+ 15.7%

Inflation comes in many forms. Food price inflation over the past decade can be directly tied to higher crop prices, which along with increasing emerging market demand, has been underpinning the current bull market in farmland prices. Considering monetary inflation, hard assets in general will appreciate to match the increased currency available in the system. Real estate is a basic hard asset, including both homes and farmland. Housing prices will have a tougher time responding to higher inflation for some time, given their oversupply and debt overhang. Farmland has no issues holding it back (other than maybe it is not starting from an especially cheap level). High inflation would probably bring higher interest rates; this will be a negative for home prices but less so for farmland prices since there is little leverage in the current makeup of farmland ownership.

In conclusion, the effects of mild monetary inflation on the already elevated prices for farmland would probably be modest, but excessive inflation would very likely carry farmland prices much higher. Given that the damage to one's portfolio from high inflation is so harsh, it is better to be safe than sorry and hold some protection now (especially important for retirees to consider). Houses could be a good choice in a few years, once they have had more time to digest their supply and debt issues; gold is volatile and earns no interest so only should be held in modest amounts; farmland is maybe the best choice since it has a very bullish case now anyway based on growing emerging market demand, plus it has a shown a high probability of protecting your wealth during extreme inflationary conditions.