How Is Inflation Impacting the Cost of Production for Dairy Farmers?

I keep seeing/hearing references to inflation and how, or if, it will impact dairy prices. It feels like the prices for nearly everything are going up, so what would stop dairy prices from also rising? From a very long-run perspective, there isn’t much connection between consumer prices in the U.S. and the farm gate milk price. Between 1950 and 2019, the consumer price index (CPI) was up 962%, but the milk price was only up 372%. How can that be?

Assuming a free market, the equilibrium price for a good should equal the cost of production. If the price is above the cost of production, there is an incentive to increase production to capture that extra profit and production will continue to increase until the price comes down to match (or drops below) the cost of production. So, what really matters for a commodity in the long-run is not the inflation rate in the economy, but the cost of producing the commodity and whether the market is “free”.

When you look at the long-run graph of the CPI versus the price of milk, the two look highly correlated from 1950 through 1980, then they diverge sharply. The Agricultural Adjustment Act of 1933 created a system of “parity prices” which were meant to “…reestablish prices to farmers at a level that will give agricultural commodities a purchasing power with respect to articles that farmers buy, equivalent to the purchasing power of commodities in the base period.” The exact definition and calculation of agricultural parity prices changed over time, but parity prices directly tied the price farmers paid for inputs to the price of outputs like milk. That link was severed in the 1980 farm bill and parity prices were no longer used to set government support levels for dairy products in 1983.

So, the question really becomes, how is inflation impacting the cost of production for dairy farmers? From here on, I’m not going to use the word “inflation” because I think it is a loaded word. The biggest expense for dairy farmers is feed, and feed prices fluctuate wildly depending on weather and government policies. Feed costs are up sharply this year, and they will likely stay high next year, but eventually crop production will rebound and feed costs will come back down. The same is true for energy costs. However, there are costs that are increasing and will probably not come back down again, like labor. Well, even that might be wrong. Maybe robotic milkers will be perfected and some of the costs will shift from labor to capital, but I’m getting off-topic.

I dug through the USDA’s estimated cost of production data for milk. The data has some limitations, but it is the best publicly available data that I know of. I chose to analyze the costs and revenues for farms in the 500-999 cow range because data for this size category is available for the past 10 years and this size farm represents a rough balancing point between large and smaller farms. I tried to tie line-item costs to broader indices, like the cost of energy for the farms back to crude oil. For costs that there isn’t a good index for (like bedding, or custom services), I assumed costs would increase by 4% this year and next year, which is roughly the pace that the core CPI has been running at in recent months.

When I work through the numbers, I think total costs will increase about 16% or $3.34/cwt. this year with only a small increase next year. Most of the increase ($2.54) is due to feed, $0.22 is due to labor and $0.57 is due to increases for all other costs. I was surprised by the results. The magnitude of the cost increase was much bigger than I thought, and I was also surprised at the impact that feed had (+$2.54) compared to all the other costs ($0.79). With total costs coming in at $24.38 and revenue (milk, slaughter cows, other) around $21.70, it looks like a difficult financial year and the big decline in cow numbers that we’ve seen starts to make more sense.

From a short-term perspective, the higher costs raise the cost of production by 16% this year, mostly driven by feed, and about 2% next year. That will keep some financial pressure on dairy farmers and limit the milk production growth, which should be supportive for dairy prices as well. Eventually, feed costs and energy costs will pull back and lower the cost of production a bit. And from a longer-term perspective farmers will find more efficient ways to run their farms, which will lower the cost of production. But short-term, higher costs will crimp production and help to boost dairy prices.

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