District outlook remains bright overall

Mid-Year Ninth District Economic Forecast

David S. Dahl | Regional Economist
Edward Lotterman | Agricultural Economist
Heidi Taylor Aggeler

Published July 1, 1998  | July 1998 issue

While prospects this year for the district economy remain quite favorable, growth may not be as strong as the models forecast last January. In addition, the agriculture forecast remains cloudy largely due to low farm product prices and inclement weather. Bank profitability continues strong, and residential real estate activity is driving loan growth.

Models forecast slower growth

The region's nonfarm employment is now forecast to increase 2.1 percent between fourth quarters 1997 and 1998, which essentially matches the growth rate in the prior three years. Last January our regional forecasting models projected a 3.1 percent increase. Employment growth projections have been revised downward for all areas of the district, except the Upper Peninsula of Michigan.

With real gross domestic product (GDP), the nation's output of goods and services, increasing at a 5.4 percent annual rate in the first quarter, the demand for district goods and services has generally been strong.

Thus, much of this slowing may be coming from employers' increasing difficulty in hiring workers. In the fourth quarter of last year the district had a low 3.4 percent unemployment rate, and by this last spring it had dropped to 2.8 percent, which suggests employers are having more difficulty hiring workers now than at the beginning of the year.

Moreover, district labor markets are expected to remain very tight. In the fourth quarter, the district's unemployment rate is expected to be 2.7 percent, which is below the 2.9 percent rate the models forecast last January. North Dakota's rate will be 1.8 percent, and Minnesota, South Dakota and Wisconsin will have rates around 2.5 percent. Rates are expected to be much higher in Montana and the Upper Peninsula of Michigan at 5 percent and 6 percent, respectively.

Besides having to cope with tight labor markets during the second half of the year, some district businesses will also have to deal with the increasing fallout from the Asian financial crisis. So far, the crisis has left district manufacturing relatively unscathed: Manufacturing employment rose 2.4 percent from a year ago during the first five months of this year. However, falling exports to Asia could curb employment growth as the year progresses.

Manufacturing Employment chart

Weather, prices create farm pessimism

Farmers inherently face uncertainty—about prices, about weather, about yields. But the level of uncertainty that Ninth District farmers faced in early 1998 was unusual even by sector standards. Global weather patterns were already showing substantial disruption as the result of El Niño; events in Asia cast doubt over prospects for export markets; and commodity prices, already highly volatile in 1996 and 1997, were eroding, and their future trend was uncertain.

Midway through the year, widespread pessimism has replaced earlier uncertainty. Although the majority of farmers enjoyed a warm, early spring with favorable planting conditions, since then some areas have suffered from excess moisture while others, principally in Montana and the western Dakotas, have suffered drought. In May and June, the Dakotas, Minnesota and Montana were subjected to a series of violent storm systems that—among other things—made hay harvesting a nightmare for many Minnesota and Wisconsin farmers as cut alfalfa failed to dry between successive storms. On the whole, however, Ninth District crops are doing well, with the exception of drought-stricken portions in the west.

Prices, though, have continued to deteriorate, with weather again playing a factor. While previous El Niño episodes frequently damaged crops in the Southern Hemisphere, the 1997-1998 El Niño was an exception. Very good wheat crops in Australia and Argentina, and soybeans and corn in Brazil, Paraguay and Argentina are contributing to lower crop prices overall.

On the demand side events in Asia also contributed to low prices. The region has taken as much as 45 percent of U.S. agricultural exports in recent years, and virtually all export growth in this decade has been to Asia. Slumping output and expensive foreign exchange sharply cut into the region's commodity purchases over the past 10 months.

Some domestic factors have also been negative for prices. Hog numbers turned out to be higher than anticipated, and hog prices fell. They have recovered somewhat, but profitability remains constricted for most producers. While cattle prices are higher than in 1995 and 1996, the cyclical recovery in prices has been stunted by the negative overall price situation, competition from cheap pork and sluggish exports of all categories of meat.

Financial problems are most severe in portions of North Dakota and northwestern Minnesota that have had recurring excess moisture and plant disease problems in recent years. In late winter, bankers in those areas described the pace of farm liquidations, largely voluntary, as the highest in more than a decade. With continuing erosion of many crop prices, equipment dealers report sluggish sales. Bankers across the district report increasing gloom as there are few signs on the horizon that give hope of higher prices.

Bank profitability strong

On a pretax basis, Ninth District bank profitability during first quarter 1998 was the same as year-end 1997 and lower than one year ago. In the past, we have not reported pretax bank profitability, but focused instead on the district's return on average assets (ROAA). First quarter ROAA was 1.25 percent, up from year-end 1997 and one of the highest quarterly returns this decade. But because of a change in the tax status of many Ninth District banks, the pretax figure allows for a better comparison of first quarter performance with prior periods.

Specifically, about one-fourth of the district's commercial banks have converted to Subchapter S tax status. The tax on the earnings of a Subchapter S bank are paid by shareholders instead of the bank itself. Thus, the conversion to Subchapter S tax status in many district banks has produced tremendous tax savings. As a result of the Subchapter S conversion, Ninth District ROAA went up during first quarter, even though profit margins, fee and service charge income, or overhead expenses did not change. The pretax measure screens out the effect of lower tax expense for Subchapter S banks, allowing for a more accurate analysis of bank profitability. Going forward, the fedgazette will include the pretax measure with the Ninth District bank performance ratios.

Since 1997, 222 or 24 percent of Ninth District banks have converted to Subchapter S tax status. (The Small Business Job Protection Act allowed Subchapter S tax treatment for eligible banks beginning in June 1997.) Forty percent of these conversions occurred during first quarter 1998.

The Ninth District leads other Federal Reserve districts in the percentage of Subchapter S banks; the next closest districts are the Tenth (Kansas City) and Eleventh (Dallas), both at 17 percent. The large number of Subchapter S conversions in the Ninth District is partially due to the concentration of small, closely held banks. Banks must have fewer than 75 shareholders to become a Subchapter S corporation.

Other banking trends

Reflective of the strong district economy, loan growth in district banks was 3.3 percent, almost double the national growth of 1.8 percent. The district loan growth was driven by a 16 percent increase in residential real estate loans during the quarter. Loans for all types of real estate grew a healthy 7 percent, and commercial loans increased by 3 percent. However, the district's installment and agricultural loans dropped by 2 percent and 4 percent, respectively.

Loan charge-offs decreased during first quarter 1998 for all loan types, while the level of delinquent and nonperforming loans increased. The increase was primarily due to seasonal factors: first quarter nonperforming loans typically increase from year-end levels for all major loan types. Still, the level of nonperforming loans remains relatively low compared with earlier in the decade.