By Theodore Young CHIEF ECONOMIST Todd May Jr. ASSOCIATE ECONOMIST Vivian Brownstein STAFF ECONOMIST Maureen F. Allyn RESEARCH ASSOCIATES Catherine Comes Haight, Lenore Schiff FARM CONSULTANT Theodore Young FORTUNE's forecast is produced by this magazine's economists using our own economic model.

(FORTUNE Magazine) – Yep, it's for real all right. Any lingering skepticism about the severity of the drought was dispelled when the Department of Agriculture released its crop forecasts in mid-August. Consumers are already starting to pay more. Farmers, paradoxically, will end the year richer than they began it, but will take some lumps in 1989. And everyone will feel the effects of the higher inflation provoked by rising crop and meat prices. In its midsummer report, which provides the first comprehensive measure of each year's crop production, the Agriculture Department laid out the extent of the damage. Acreage planted was not much changed from last year, but yields plummeted as cloudless skies and searing heat took their toll in almost every important growing region. As of August 1, grain production is expected to be down 31% from last year -- a whopping 85 million tons -- to the lowest level since 1970. The corn crop, the U.S.'s most important, is likely to be 4.48 billion bushels, 37% less than a year ago and 50% below the 1985 record. Wheat is down 13%, oats and barley each 45%, sorghum 24% -- and so on. The soybean crop, down 23%, is the smallest since 1976. Things could get a bit worse yet. After a burst of heavy rainfall, hot dry weather has returned to the Great Plains and the rest of the Midwest and is expected to prevail until the end of the month, so that production may be somewhat lower. Insects are adding to the woes in some states. In Ohio, for example, spider mites have flourished in the heat, and are attacking soybeans. The shortfall won't mean catastrophic grain scarcities. Ample stocks left over from last season will help fill the pipelines, and domestic demand will be somewhat lower as livestock producers liquidate herds. Foreign production & is forecast to rise 2%. Output is up in Western Europe, Australia, and Thailand, all major exporters of grain; the U.S.S.R., a major importer, will have a large crop. But U.S. stockpiles during the 1988-89 marketing season will still be the lowest since 1983-84, another drought period, and grain stocks this time next year will be down 55%. Meanwhile, the U.S. will lose some export markets it had recaptured over the past year. The sharp depletion of supplies is sending crop prices to their highest levels in four years. Corn shot from $1.60 a bushel in July 1987 to $2.89 last month, a gain of 81%. Soybeans rose 69%, and wheat 49%. Altogether, if futures prices are any guide, crop prices this quarter will likely be 30% above a year ago. They will continue rising, but less rapidly, through the second quarter of next year, and then begin a sharp descent. Southern Hemisphere crops will be available in the winter, and more U.S. land will be brought back into production in 1989 -- perhaps 20 million acres. For all of 1988, crop prices will be up almost 20%; assuming normal weather, they will climb an average of about 5% more next year. As rising feed costs force livestock producers to liquidate their herds, meat supplies generally increase before output falls. True to the pattern, meat production is expected to swell temporarily this quarter. But emergency haying and grazing on land withdrawn from production, along with USDA feed assistance programs, are sparing farmers the need to slaughter drastically. Assuming pasture and rangeland conditions improve in the fall, meat production will rise about 3% this year to a record level that is slightly larger than predrought estimates, then drop a little more than 1% next year. Beef output will plunge 4% or so because ranchers will be keeping their remaining breeding stock in order to rebuild herds. Hog farmers will call a halt to the sharp expansion in sow farrowing they started earlier in the year, so pork production will fall 1% or so next year after increasing 9% in 1988. Poultry production rarely seems to waver. Output is on a long uptrend as consumers continue to favor white over red meat for health reasons. Still, higher feed costs will slow the growth in production to 3% next year, vs. 4% this year. LIVESTOCK PRICES will mirror the pattern (see chart at right), falling this quarter and next and then spurting upward in 1989. Trends in the futures markets suggest they will peak in the third quarter as hog prices approach $50 ! per hundredweight. Cattle prices should top out at about $75 per hundredweight, the highest ever, and then retreat slightly. Cattle and hog prices will both be up about 7% for the year; poultry and dairy prices will rise somewhat less. All in all, livestock prices could increase nearly 6% next year, compared with 1% in 1988. Consumers are already paying more in grocery stores and restaurants. Retail food prices will climb at a 6% annual rate this quarter, slightly more than the rise expected in the consumer price index. Affected is everything from fresh fruits to such processed foods as cereals, bakery products, fats and oils, and vegetables. Though the rate will drop sharply in the fall when the drought's early impact weakens, it will quicken next year as livestock prices accelerate. The costs for processing and marketing foods, which rise in tandem with overall inflation, will also climb. Food prices will actually trail inflation this year, increasing at a 4% rate, but next year's rise of 6% will add to the pressure. And what of the farmers? You can grieve for the individuals whose sad stories make the news, but in the aggregate 1988 will be an astonishingly good year. Net farm income, which in the arcane accounting of the Agriculture Department is reduced by sales of stored crops, will be perhaps $1 billion below last year's $46 billion -- a record figure that was 22% above the previous year. But net cash income, which does not reflect inventory changes, could set a new record of $60 billion -- more than $3 billion above last year. Higher prices will more than offset lower volume for crops. But the real tonic comes from government payments, pumped up by the recently signed Disaster Assistance Act of 1988. The Congressional Budget Office estimates the benefits at $5.1 billion, the largest aid package ever offered. Direct federal payments to farmers could reach $16 billion, only $1 billion less than the 1987 record. But it's an ill wind that blows no good. Total federal outlays next fiscal year could be reduced some $7 billion, since less will be paid out in crop subsidies. In any case, the money farmers get will go farther than ever because production costs have declined sharply since the mid-1980s. Like their brethren in industry, farmers have been focusing on the bottom line, restructuring and cutting costs. As an added bonus, this year they will be selling stored crops at high prices. Perversely, if rainfall is normal next year and crops do better, farmers | will fare worse. While cash receipts could rise $7 billion to $8 billion, direct federal payments will drop sharply. At the same time, production expenses will jump. Apart from planting more, farmers will face higher prices for feed, seed, fertilizer, chemicals, and equipment. Net farm income may not be much different from this year, since farmers will be building up inventories. But net cash income will be down significantly, probably falling below the level of 1987. At that point, many farmers might start remembering the brutal summer of 1988 a bit more fondly.

BOX: OVERVIEW -- The shortfalls will push crop prices up this year, and meat prices next.

-- Farmers' cash income could reach a record $60 billion.

-- But diminished crop subsidies will lower federal farm outlays in fiscal 1989.

-- Interest rates should hold steady until next year.

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: RETAIL FOOD PRICES DESCRIPTION: Retail food prices, 1983-June 1988 with forecast for July 1988- 1989.

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: FARM PRICES UP ON THE FARM Crop prices will soar this summer, but meat prices will edge down as farmers liquidate herds. Next year the livestock gallop. DESCRIPTION: Total crop and livestock prices, 1983-June 1988 with forecast for July 1988-1989.