ECON430-Topic #3: Investment and Interest Rates

One of the fundamental economic theories of economics is that changes in real interest rates should have an impact on output. There are several channels through which monetary policy is expected to impact the overall economy. As noted by the Austrian central bank, through the interest rate channel “a raise in key interest rates triggers an increase in short-term market rates. As a result, both the real interest rate and the cost of capital rise, putting a brake on investment.” The Bank of Canada also notes:

The main transmission channel is the effect that changes in the Bank’s policy rate have on various commercial interest rates, e.g., for mortgages, for consumer loans, as well as for deposits at financial institutions. A decline in commercial interest rates reduces both the cost of borrowing and the money paid on interest-bearing deposits, which tends to encourage borrowing, spending and investing, and to discourage saving.

–Bank of Canada

However, Federal Reserve economists Steven A. Sharpe and Gustavo A. Suarez have recently put together a report that shows many firms are not particularly sensitive to changes in interest rates.  As noted in their abstract:

A fundamental tenet of investment theory and the traditional theory of monetary policy transmission is that investment expenditures by businesses are negatively affected by interest rates. Yet, a large body of empirical research offer mixed evidence, at best, for a substantial interest-rate effect on investment. In this paper, we examine the sensitivity of investment plans to interest rates using a set of special questions asked of CFOs in the Global Business Outlook Survey conducted in the third quarter of 2012. Among the more than 500 responses to the special questions, we find that most firms claim to be quite insensitive to decreases in interest rates, and only mildly more responsive to interest rate increases. Most CFOs cited ample cash or the low level of interest rates, as explanations for their own insensitivity. We also find that sensitivity to interest rate changes tends to be lower among firms that do not report being concerned about working capital management as well as those that do not expect to borrow over the coming year. Perhaps more surprisingly, we find that investment is also less interest sensitive among firms expecting greater revenue growth. These findings seem to be corroborated by a cursory meta-analysis of average hurdle rates drawn from firm-level surveys at different times over the past 30 years, which exhibit no apparent relation to market interest rates.

 –Steven A. Sharpe and Gustavo A. Suarez

So, while there are other channels through which monetary policy works this fundamental one seems to be ineffective in the last couple of years. The “portfolio balance channel” is another which is expected to help improve economic conditions through changes in the quantity of existing reserves. Quantitative easing in particular, is expected to have different effects when the central bank is facing the “zero-lower bound” on policy rates. Fed economists Fawley and Neely examine these channels in more detail.

Questions you might answer:

  • Can the central bank affect the overall economy through the interest rate channel? How large is this effect expected to be? What do the authors above have to say about the effectiveness of monetary policy over the last several years? You do not have to read all these papers, but try to gain some deeper insight about policy by reading at least one of them and some related news articles.
  • If the Fed is poised to raise rates, and there is no impact on overall investment, how can the central bank impact demand in a way that avoids accelerating inflation?
  • If the Fed is poised to raise rates, and that negatively impacts investment, then why do stock markets positively react to this? Wouldn’t the subsequent fall in investment lead investors to think that the overall value of the stock market would fall in the future?

13 thoughts on “ECON430-Topic #3: Investment and Interest Rates”

  1. Although it is not cheerful news for proponents of monetary policy, the Sharpe and Suarez article listed above is not the evidence of drastic ineffectiveness of commercial interest rates that if first appears to be. The authors asked questions to CFOs about how their investment would respond to changes to interest rates of the next year (asked in Sept. 2012).

    Businesses seemed to be highly insensitive to decreases in the interest rate. However, lending interest rates have been at a historic low [1]. If the effect of decreases interest rates on investment follows diminishing returns, then it is no wonder businesses might not respond to further decreases.
    So why then were businesses also mildly insensitive to increases in the interest rate? One possible answer lies in the question asked by the authors. They asked about increases from 0.5% to 3.0%. Well at a 3.0% increase from 2012 lending levels, the interest rate is still two points below 2007 levels [7]. Not a bad rate historically. Further, in order for businesses to delay investment in the following year, they would have to assume the interest rate would go back down later. Assuming these are relatively critical investments and because there is no way to forecast in these hypothetical scenarios, there is no reason to delay investment.

    The researchers Sharpe and Suarez were not wrong to ask any of the questions they did in their report. However, the data that they used must be analyzed in the economic climate that it was taken.

    [1] databank.worldbank.org/data/US-Lending-Rates/id/ad87269f

  2. Increases in interest rates would logically deter the interests in holding stocks. In an inflationary environment, stocks react to falling interest rates in a positive manor (1). This is because low interest rates typically increase economic activity and allow greater margins for profit. People with more disposable income typically buy more, which in turn, puts money back into the economy. This is not always the case however, because “rising interest rates could actually be a good thing”(2).

    The increase of interest rates could be seen as a sign that the economy is on a path to recovery and/or growth. Scott Wren (senior equity strategist of Wells Fargo Advisors) claims that the stock market would love to see an increase in interest rates because over the course of history, “economic expansion has always been good for stock prices.” When investors see signs of a growing economy, they are generally attracted to the investment opportunities a growing economy offers. Apart from giving evidence to a growing economy and attracting investors, increases in interest rates “may increase the expected excess return (i.e., the equity premium) associated with holding stocks”(3). By increasing the expected returns, stocks become more attractive to investors thus giving stock markets a positive reaction to the fed raising rates.

    The reaction/relationship between interest rates and stock markets isn’t strong as one could see in the following chart. (http://www.etf2x.com/wp-content/uploads/2009/11/fedfundsrate3.jpg) The market seems to raise and fall independently of changes in the FFR to the point that some economists argue that there is no relationship between the two at all (4). One relationship that is certain is the fact that both are increasing in the long run as the economy grows.

    1.http://stockcharts.com/school/doku.php?id=chart_school:overview:intermarket_analysis
    2.http://www.bankrate.com/finance/investing/stocks-and-rising-interest-rates.aspx
    3. http://www.newyorkfed.org/research/staff_reports/sr174.pdf
    4. http://www.tradersnarrative.com/think-that-central-banks-move-the-markets-think-again-2495.html

  3. According to the study conducted by Sharpe and Suarez, the vast majority of CFOs state that their investment plans are “quite insensitive to potential decreases in their borrowing cost (1).”
    More specifically, 68% of CFOs do not expect any decline in interest rates would induce more investment (1).

    This logic goes against the standard economic reasoning that firms benefit from lower interest rates, as lower rates supposedly encourage more investment due to lower borrowing costs. The most commonly cited reason in the paper for refuting this typical economic reasoning revolves around the idea that debt is not a marginal source of finance. Most of the firms use ample cash reserves or sufficient cash flows to finance investment. Thus, these authors’ findings begin the discussion regarding the relationship between investment and interest rates (1). The results point towards ineffectiveness in the interest rate monetary policy approach.

    There could be several reasons as to why this monetary policy is ineffective. It is possible that this policy loses much of its effectiveness at the zero lower bound (3). Economist, Richard Koo of Nomura Research, attributes the problem to that fact that highly indebted firms are merely unable to respond to lower long-term rates by borrowing more (3). It is also possible that firms do not believe the commitment to the policy by central banks. If the central banks waver or stall implementation of an announcement to change interest rates, firms do not associate much confidence with that policy.

    While it is not easy to pinpoint one specific reason for the ineffectiveness, the ideas listed in the previous paragraph give some insight as to why the interest rate monetary policy approach does not work.

    1) http://www.federalreserve.gov/pubs/feds/2014/201402/201402pap.pdf
    2) http://www.investopedia.com/articles/stocks/09/how-interest-rates-affect-markets.asp
    3) http://www.economist.com/news/schools-brief/21586527-third-our-series-articles-financial-crisis-looks-unconventional
    4) http://www.global-rates.com/interest-rates/central-banks/central-banks.aspx

  4. Diving deeper into the Sharpe and Suarez paper, I have a couple of issues with the methodology that the two used to measure firm’s insensitivity to interest rates. Their findings indicate that 68% of respondents would not likely change to a decrease in interest rates. Mind you, this survey is being taken in September 2012, when interest rates are bottoming out. The respondents were all asked an open-ended question why they weren’t sensitive. The paper cites one of the most popular reasons as “interest rates are already low.” If you look at the other end of the spectrum, 63% of firms would react in some instance to an increase in interest rates. This is very close to the amount of firms that claimed to be insensitive to a decrease in rates. It would be very interesting to see if these same results hold in times with different interest rate environments.
    The study is done based on a survey of CFO’s answers to hypothetical survey questions. Given the inherent bias with hypothetical surveys, these answers could be completely invalid. There is an incredibly strong difference between what people say they would do and what they would actually do. Sharpe and Suarez note that this is an anonymous survey so there is no identification bias in the survey, but still what is causing these CFO’s to disclose an actual investment strategy. To me, it would seem that a CFO would be more likely to say that the firm is fine relying on its cash flows or steady revenue streams to make planned investments, as opposed to timing the market with interest rates. I would love to see some form of empirical test that puts actual investment behavior of firms to the changes in interest historically. These results would hold much more empirical weight than the regression ran on how rate sensitive a CFO said his or her firm is in an online survey in one year.
    Although the paper may show some evidence that the link between investment and interest rate is weaker than thought, the paper isn’t exactly compelling empirical evidence. The inherent bias in a hypothetical survey, the low rate environment surrounding the time of the survey, as well as the one sidedness of the sensitivity poke holes in the validity of the empirical results found.

    http://www.federalreserve.gov/econresdata/notes/feds-notes/2013/do-cfos-think-investment-is-sensitive-to-interest-rates-20130926.html
    http://www.federalreserve.gov/pubs/feds/2014/201402/201402pap.pdf

  5. Frederic Mishkin points out the multiple channels a monetary authority can use monetary policy to impact an economy. The interest rate channel is one of the ways. Basic IS-LM analysis shows one way that interest rates can speed an economy, by increasing money supply. Increasing the money supply lowers the real interest rate, which would lead to an increase in investment. Following the basic GDP model, an increase in investment increases GDP (1). In addition, when the nominal interest rate is at a floor of zero, you can still increase the money supply and lower the real interest rate, by following this logic:

    If M increases, the expected price level increases. When the expected price level increases, you see expected inflation to increase, which would lower real interest rates (recall that real interest rates is measured by nominal interest rates minus inflation). This lowered inflation rate increases investment and in turn increases output (1).

    If this model holds, the Austrian central bank as well as the Bank of Canada’s assessment holds true, having a mechanism that increases the real interest rate would lower investment. Mishkin cites a view from Taylor (1995) which was controversial for supporting the ISLM paradigm. Bernanke and Gertler wrote a paper in 1995 which contradicted the IS-LM interest rate channel. Mishkin concludes, however, that there is an “empirical failure” behind the interest rate channel, since there is contradicting results.

    If the fed raised rates, and there isn’t an impact on overall investment, the central bank can go through other channels without harming inflation. One approach is from the credit channel. Mishkin defines this monetary policy effect to follow this logic:

    If M increases, bank deposits will increase. If bank deposits increase, bank loans will increase. This increase in loans will lead to an increase in investment, which in turn increases output (1).
    However, there is more debate over this channel also. Ramey (1993) and Meltzer (1995) provide a stance against this approach (1).

    (1 )http://www.nber.org/papers/w5464.pdf

  6. Recent studies have shown that firms are not very sensitive to changes in interest rates. With the Fed set to increase interest rates, the Fed may have to prop up aggregate demand in order to sustain the recovery, even if higher rates have no impact on investment. This is problematic since QE has dramatically increased the monetary base, and the economy runs the risk of serious inflation if conditions return to “normal”. So if an increase in interest rates does not cause a significant change in investment, how can the Fed stimulate aggregate demand without accelerating the potential for inflation?

    Economists have identified two channels central banks may use to affect demand without accelerating inflation. These are the Portfolio Balance channel, and the Signaling channel.

    Signaling Channel:
    The signaling channel is the method by which the Fed hopes to stimulate aggregate demand through the manipulation of investor expectations. The central bank can announce that they plan to change interest rates or inflation, and hope the market reacts to their announcement in a desired manner. This approach does not cause necessarily cause inflation because the Fed does not have to actually do anything to get the market to react. However, this approach relies on the assumption that investors believe the Fed will act, and the expectations hypothesis of the term structure of interest rates: that investors accurately predict future interest rates and are willing to substitute between different length securities, as long they get a higher yield (2). However, both the expectations hypothesis and the effects of signaling theory have not been proven by empirical studies (1) (4)

    Portfolio Balance Channel:
    Another way the central bank could affect aggregate demand without accelerating inflation is the Portfolio Balance channel. This approach entails the Fed buying up longer term securities in order to change the quantity and mix of financial assets held by the public. These purchases include government and mortgage-backed securities. This serves to lower long-term rates and sustains housing finance, and makes homebuyers more confident and have more disposable income. In theory, this should increase aggregate demand. (3) However, there is no empirical evidence across several studies that the portfolio balance approach has led to the decline in long-term rates. (4) (1)

    In theory, the signaling and portfolio balance channels allow asset purchases to lower long real rates and stimulate the economy without inflationary pressure. (1) While empirical evidence does not necessarily support either channel as a serious contributor to interest rates or aggregate demand, most authors acknowledge more research needs to be done. (1) (2)

    (1) Bauer, M.D., and G.D. Rudebusch. (2011) “The Signaling Channel for Federal Reserve Bond Purchases,” Federal Reserve Bank of San Francisco Working Paper 2011-21.
    (2) Fawley, Brett W., and Christopher J. Neely. Four Stories of Quantitive Easing (n.d.): n. pag. St. Louis Fed. St. Louis Fed, 1 Feb. 2013. Web. 26 Mar. 2015.
    (3) Molthai, Koshy. “Finance & Development.” Monetary Policy: Stabilizing Prices and Output. IMF, n.d. Web. 26 Mar. 2015.
    (4) Thornton, Daniel. “Evidence on The Portfolio Balance Channel of Quantitative Easing.” (n.d.): n. pag. St. Louis Fed. St. Louis Fed, 1 Oct. 2012. Web.

  7. Interest rates and Stock prices are thought to be inversely related for two reasons. First when interest rates are low stocks appear to be more attractive to bonds. The second reason is when interest rates are low it is cheap to borrow money. When it’s cheaper to borrow money you are more likely to purchase “big ticket” items like cars and houses. When these are purchased it helps to create a positive outlook on the economy and stock market returns (1).
    However, “when the 10-year Treasury yield was below 5 percent, rising interest rates were generally associated with rising stock prices.” The main reason for this is because when the Fed raises interest rates and it signals investors the problems with the economy are over and the economy is on the rise (1). So the Fed raising rates can actually help investment if it signals investors that the problems with the economy are over.
    (1) http://money.usnews.com/money/blogs/the-smarter-mutual-fund-investor/2013/05/24/will-rising-interest-rates-hurt-the-stock-market

  8. The typical economic ideas on interest rates’ ability to effect investment and borrowing have been challenged in the recent economic state. 1)According the article by Sharpe and Saurez many CEO’s have stated that they are insensitive to borrowing costs. This is the opposite of traditional views that as interest rates (borrowing cost) fall there is more borrowing and it sparks investment. 2) Fawley and Neely have suggested that in the current economic state with interest rates at a near zero bound that an effective policy would be to announce a zero interest rate for the long term, an the as there are improvements the economy would return to normal policies (Eggerston’s committing to be irresponsible idea). 3) The Bank of Canada explains that an increase in interest rates can lower asset prices, lowering wealth, hurting investment spending. Viewing these three ideas it seems evident that the central bank can effect the economy by using interest rates. The effect is hard to discern because the most current situation i.e. near zero lower bound it is unprecedented area. The fed currently believes that they can use increasing interest rates to help wane off the current policy, but Janet Yellen is adamant about doing this cautiously and gradually. He patience and uncertainty about the near future makes the impression that even the fed is confused about possibilities.

    1) http://www.federalreserve.gov/pubs/feds/2014/201402/201402pap.pdf
    2)https://research.stlouisfed.org/publications/review/13/01/Fawley.pdf
    3) http://www.bankofcanada.ca/wp-content/uploads/2010/11/how_monetary_policy_works.pdf

  9. The crowding out of investment due to rising interest rates is mainly a concern when it comes to physical capital. For example, if a firm needs to borrow money in order to purchase new machines for production and interest rates have increased, they will have to pay more now for the same amount of capital yesterday. Therefore, a fall in investment would occur and assuming rational expectations hold, firms may delay investment in the future because of the expectation that interest rates will rise further in the future.

    However, when it comes to financial assets in the stock market, it makes intuitive sense that an increase in interest rates would cause a positive stock market reaction. The reason for this is the inverse relationship between interest rates and bond/asset prices. If the Fed only plans on raising rates, investors looking to buy will be most likely to buy today before bond prices rise and those looking to sell will postpone their activity until interest rates do increase. Taking a look at the most recent announcement about a gradual interest rate hike in the United States [1], it appears that the stock market has reacted positively to this news [2]. The reason for this may be that Janet Yellen’s announcement has increased the transparency in the intentions of the Fed, allowing for investors to adjust accordingly through trustworthy information. There are some opinions that state that if the interest rate increase occurs gradually, there will be no large effect on the stock market, despite the fact that the stock market has already had a positive reaction simply on the basis of the announcement of increased interest rates in the future [2]. If investment were to be crowded out, based on adaptive expectations, investors may believe that the value of the stock market would fall. Because adaptive expectations have been replaced by rational expectations and we assume rational expectations hold, investors predictions may not suspect the value of the stock market to decrease.

    [1] http://www.cnbc.com/id/102541816
    [2] http://www.cnbc.com/id/102540703

  10. We have been taught throughout our coursework about the inverse relationship between interest rates and stock prices. However, the articles above point out that investment plans are more insensitive to interest rates than originally thought. Sharpe points out that only “8% of firms would increase investment if borrowing costs declined 100 basis points” (1). A strong factor that would effect a firms decision is whether or not they plan on borrowing money to finance their investment. Another strong factor leading to this insensitivity is whether or not a firm has expectations for revenue growth over the coming year. Intuitively this makes sense, because if a firm was going to borrow money to fund their investment they would obviously want a lower interest rate on what they are borrowing. Also, if a firm has high expectations for a good quarter, investment spending may have no cap on the budget. When asked about the insensitivity to interest rates and investment spending, most cited the firm’s ample cash reserves or cash flow as the reason (1). Once again we would expect a firm with more cash flow to be willing to take riskier investments regardless of the interest rate. As for the assumption that fluctuations in the interest rate can effect investment and in fact increase or decrease output, we will let that slide for the sake of our models. However, the articles above paint a different picture.

    (1) http://www.federalreserve.gov/pubs/feds/2014/201402/201402pap.pdf

  11. Because the “Federal Reserve has primarily influenced overall financial conditions by adjusting the federal funds rate” (1), many question to what extent other rates are tied to the federal funds rate and how sensitive consumers are to interest rate changes. Theoretically, “when short- and long-term interest rates go down, it becomes cheaper to borrow”, and, in response , consumers are more willing to borrow (1). In an analysis comparing time-series graphs of the federal funds rate against various other interest rates, the writer argued that the federal fund rate noticeably and obviously impacted housing, auto, and financial markets (2). From june 2007 to September 2012, while the federal funds rate plumetted from 4.5% to 0%, the 30-year fixed rate descended from 6.5% to 4.5%. This article appeared to strongly assert this decrease occured because the fed lowered their rates; however, other factors in the housing market, such as the existence of mortgage backed securities being purchased by the fed, housing dilenquencies(3), etc. In inaddition, the auto-industry displays a similarly inconclusive trend. Recently, a study illustrating insensitivty to interest displays stated that “”most CFO’s cited ample cash or the low level of interest rates, as explanations for their own insensitivty” (4). Theorists all admit that ‘linkages’ between investor behavior and interest rates “don’t show up immediately” (1); but, one would think that a sudden drop in the federal funds rate, as in 2008, one lead to a someone sudden drop in other interest rates. While this sudden drop was somewhat apparent in financial industries, the same cannot be said of auto or housing industries. In general, the impact of monetary policy is highly inconclusive.
    1. http://www.federalreserve.gov/faqs/money_12856.htm
    2. http://www.bankrate.com/finance/federal-reserve/federal-funds-rate.aspx
    3. http://www.bloomberg.com/news/articles/2012-05-16/mortgage-delinquencies-in-u-s-fall-to-lowest-since-2008
    4. http://www.nber.org/papers/w5464

  12. When interest rates rise there seems to be some negative effect on investment in many assets like bonds. Most people will move their money elsewhere. The popular move is to move money into the stock market. Many also believe that monetary policy also indicates positive expectations of the economy from the Fed.

    Ben Bernanke states, “it reflects an improving outlook for economic growth and less risk of deflation.” Both are welcome developments to equity investors. Moreover, “it results in losses for bonds,” he said, which may prompt investors to sell those bonds and move money into stocks (1).

    One example of this occurring in the past was after the recession in 2000. A couple years after the recession interest rates were kept low until sometime during 2004 which is demonstrated in the graph that displays 3-month T-bill rates between the years 2000 and 2007(2). The S&P 500 showed an upward trend in the time period after 2004 in which interest rates were rising(3). The S&P 500 increased by almost 28% in the years 2004-2007.

    1) http://www.nytimes.com/2013/06/02/your-money/when-interest-rates-rise-stocks-neednt-fall.html?_r=0
    2) https://research.stlouisfed.org/fred2/graph/?graph_id=230415&category_id=
    3) http://finance.yahoo.com/echarts?s=%5Egspc+interactive

  13. There should be very little doubt in the public sector that the Fed will increase interest rates in 2015. There is a large amount of debate as to when such an increase will happen: June seems like a possibility, although officials are being non-committal on a date. Labor markets will ultimately determine when the Fed decides to increase interest rates (1). According to a report released by the Fed on March 4th, labor markets have began to recover from a year ago across districts in manufacturing, and nonfinancial sectors. However, the agricultural sectors remained low, reflecting “persistent” droughts (2). In sum, a rise in interest rates might be an appropriate course of action in the upcoming months.
    However, if interest rates have a negative effect on investment, then why do we see an increase in stock prices after interest rates are hiked? According to a recent news article, interest rates might have a relationship with stock prices that is not portrayed in Keynesian models. Following the announcement of a potential interest rate hike by Janet Yellen, ABC news reported on March 18th that the DOW Jones increased by 227 points, after being down by nearly 100 points (3).
    It would seem that a simple answer is to say that rising interest rate targets by the Fed indicate to investors that the Fed believes that the economy has recovered sufficiently to warrant the introduction of expansionary policy tactics. This alone may increase producer confidence such that believe they will be able to see a return on future investment.

    (1) http://www.usnews.com/news/articles/2015/03/23/fed-vice-chairman-stanley-fischer-shifts-focus-beyond-impending-rate-hike
    (2) http://www.federalreserve.gov/monetarypolicy/beigebook/beigebook20150304.htm
    (3) http://abcnews.go.com/Business/stocks-soar-fed-hints-interest-rates-rise-job/story?id=29734683

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