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
In the US, it is supposed to work much the same way. At a fundamental level, the Federal Reserve has many explanations of how monetary policy works to impact employment and inflation. The mechanics of this are to utilize changes in the Fed’s familiar policy instruments as explained by the St. Louis Fed for one basic example and San Francisco for another more detailed story. The New York Fed–who actually conducts the open market operations–explains what happens in the greatest and probably most accurate detail. However, the traditional story does not seem to work well when the central bank’s balance sheet is where it is now. There have been many stories about what the Fed needs to do in order to “normalize” monetary policy after the crisis, but they do not seem to be in much of a rush to get to this point.
Furthermore, 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. Finally, Ben Bernanke himself authored several papers explaining how the “financial accelerator” channel would work during a period of interest rates at the zero-lower bound.
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 choose one or two to try gain some deeper insight about policy. You may also choose to 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? Think about what the Fed is saying about the current state of the economy if they are saying that it is OK to raise rates.
11 thoughts on “ECON430-Topic #3: Investment and Interest Rates”
Looking at the S&P 500’s performance during Fed tightening periods, after an initial knee-jerk sell-off the market has consistently delivered positive returns. Following the Federal Reserve’s most recent rate hike in December 2015, the S&P 500 climbed higher, returning over 2.5%. This return is counterintuitive to expectations of what returns should be given that the cost of borrowing increases which, in turn, results in compressed firm profitability. But when the Federal Reserve raises rates, what is on the forefront of the minds of investors is not reduced firm profitability but the perception of a strengthening United States economy. The Fed has stated frequently that it is data dependent and will only act if several metrics pertaining to employment, growth, and inflation support a rate hike. As a result, a Fed rate hike is taken more as a vote of confidence for the United States economy rather than something that may harm U.S. firms. But, there remain two factors that may be supporting this trend that are subject to change in the future. First, is the current low rate environment that the United States economy finds itself. A hike from 0.25 to 0.50 basis points is fairly immaterial and still allows firms to borrow at historically low levels. More firms may experience financial stress after a hike if it were a move from 175 to 200 bps. Second, a 25 basis point move is not a large hike and firms can likely withstand the higher borrowing costs whereas a 50 or 75 basis point hike could induce a greater negative effect. While these scenarios do need to be accounted for, current Fed rhetoric does not indicate that these two situations could happen anytime soon.
In an attempt to bring the economy back to ante-recessionary levels, the FOMC – The Fed’s monetary policy committee – decided to undergo normalization of monetary policy. This policy includes three steps, the first being “liftoff”, which is the FOMC’s term for raising its target interest rate. Liftoff occurred on December 16th, 2015 as the Fed raised rates a whole quarter of a percentage point. Although much anticipated, both domestic and global economies welcomed the rate hike with open arms. In the United States the Dow jumped 224 points and was accompanied by a 1.5% increase in the S&P 500 and NASDAQ while countries abroad such as Japan, China, London, and Paris seemed to rejoice as well. These untypical reactions can be attested to the significance of this small, yet integral increase in rates, which was a signal from they fed saying that the economy was back on track to recovery.
In normal times, the interest rate channel is used in an attempt to incentivize or deter investment in the economy, but as we have come to find out, these are not normal times. It seems as if modern day firms have become desensitized to the aforementioned incentives and deterrents imposed by interest rates, which could explain why a fall in investment was nonexistent, in fact it was the exact opposite. A study conducted by Federal Reserve Economists Steven A. Sharpe and Gustavo A. Suarez, produced interesting results concluding that only 16% of the firms in their study would reduce their investing due to an increase in rates. Thus, one can infer from this information and from the current economic circumstances that whether firms and investors are concerned about rates or not, an increase (a positive sign from the Fed) would not only have a dulled response from a majority of firms, but would actually be perceived as an increase in the value of the market in the future.
http://money.cnn.com/2015/12/16/investing/stocks-markets-fed-rate-hike-interest-rates/ ** This one has a great picture of our Fed’s President
If the Fed announced that it would raise interest rates and investment had no change yet they still wanted to impact demand that didn’t add inflation they could conduct monetary-policy through a credit channel. This would allow banks to stop lending so freely and start buying bonds due to the increase in key interest. The interest rate increasing would make banks who wanted to refinance themselves more difficult and therefore banks would make fewer loans. Both households and banks then are forced to forgo consumption which in turn would decrease inflation. The value of a dollar would be worth more and therefore be deflationary because the lack of spending causes less money to be in circulation. Investment is not increasing because the restriction on cash should cause less investment. However, those who would invest also could recognize that the Fed has no credibility of commitment when they announce interest rates and therefore would not allow the temporary surge to impact their overall decisions. The firms and individuals that would continue investing, keeping I constant, are those with a large amount of cash and liquidity as suggested by the study of CFOs by Sharpe and Suarez. Fawley and Neely’s theory is not in line with the study arguing that a credit channel would cause fraudulent borrowers that banks wouldn’t want to lend to due to their riskiness of repayment. They came to this conclusion by incorrectly assuming if credible borrowers (liquid borrowers) would perceive the interest as negatively affecting their profitability, which was shown to be a false assumption by Sharpe and Suarez. Bernanke agrees with the effect of the transmission of monetary-policy restricting spending, his only argument is whom the borrower is. His discussion highlights the financial accelerator has firms and households as the ultimate borrowers and the credit channel’s method has the borrowers as financial intermediaries. Financial intermediaries being the borrowers is more cohesive with the study, seeing as Bernanke reports household’s net worth can be effected significantly by changes in key interest making borrowing and investing less likely. Financial accelerator approach would contradict the argument that changes in interest rates have very little to do with overall investment while trying to change demand. Firms and households would be the main borrowers in which case their investment would have to change in order effect the demand which is why the credit channel transmission is the best approach.
As is noted by the Fed’s article, central banks can seek to influence the economy in the short-run by altering the financial conditions that firms and households face in their decision making through manipulation of short-term nominal interest rates. However, as Mishkin notes, economic actors make decisions based on the real interest rate; through sticky prices changes in the nominal short-term interest rate also affect the real short-term interest rate which results in changes to the long-term real interest rate. These changes make borrowing and investment relatively more or less attractive which can eventually have impacts on employment.
However, the size and consistency of the effect of interest rates on investment is debatable; Shape and Suarez find that firms are less sensitive to a fall in interest rates than they are to a rise. In fact, 8% of firms would increase investment if rates fell by 100bps while 16% would decrease investment if rates rose by 100bps. Sensitivity to interest rates is most prevalent from firms that have working capital concerns and are planning to borrow at least some of their investment funds while firms expecting high revenue growth are relativity less sensitive. Hence, the study by Sharpe and Suarez suggest that monetary policy through the interest rate channel is largely ineffective and only impacts the investment decisions of some firms. They note that 68% of firms in their survey report that any decrease in interest rates would not induce greater investment. Moreover, this does not seem to be an uncertainty problem, but simply one resulting from firm indifference to interest rate changes; the article notes that only a small number of firms cited high uncertainty as a reason for being insensitive to interest rate decreases.
While it is often stated as fact that central banks can spur aggregate demand and thus inflation and employment through cutting interest rates, the empirical evidence does not always suggest this to be true, especially during the past several years of low inflation and GDP growth. The economic theory is logical – cut interest rates to incentivize investment and consumption – but this is contingent on the expectations, desires, and other various factors involving both firms and consumers. For consumers the factors may include income growth, credit score, debt burden, and expectations about future economic prosperity. At the firm level such factors include interest rate expectations, risk involved with investment, and consumer demand. During the Great Recession, many consumers lost jobs, missed payments, and carried debt burdens greater than the value of their assets (mortgage specifically). With this lower demand, firms layoff employees, cut investment, and deleverage. This cycle perpetuates itself since without economic strength in either entity, the other cannot prosper or at least lacks an incentive/ability to spend.
Even with low costs of borrowing at the consumer and firm level, why would either consume/invest in a weak economic environment? If I lose my home, default on my mortgages, miss several bills, and thus have a dismal credit score then who will lend me money? If my business contracts due to lower demand for my product, why would I borrow money to expand? If I am a bank and the risks associated with lending increase while interest rates decrease, why would I want lend money? These are fairly basic questions that simply dropping interest rates do not address.
Per the St. Louis Fed (Kliesen, 2011), although net interest margins of banks increased to its highest level in seven years after the FOMC reduced the federal fund rate, commercial loans on bank balance sheets decreased by 25% during the same period. The banks had every reason to a) deleverage and b) increase restrictions on lending and there is nothing that low interest rates do to resolve their incentive. Another example of an issue that low interest rates do not resolve is lack of firm sensitivity to interest rates. An FRB survey of 500 CFOs (Sharpe and Suarez, 2014) found that the majority claimed to have ample cash and thus low interest rate sensitivity. This would imply that, even accounting for expectations, firms will likely not borrow at an increasing rate as time runs out on low interest rates (assuming normalization is the Fed’s plan). The simple fact is that real economic recovery takes time and that growth and inflation necessitate some more direct driver of investment/spending than low interest rates.
The Fed currently has currently not been very effective in recent years with regards to investment and output. Theoretically they should be able to effect these variables, even if the zero lower bound has been reached during a recession but recent years have been telling us otherwise. According to the paper by Sharpe and Suarez, firms even in 2012 did not believe interest rates would affect them and their levels of investment and output very much, stating low interest rates as one of the reasons to this insensitivity. One theory that explains why the economy has not been able to be effected by the interest rate channel is that the U.S is undergoing a “Credibility Problem.” Because Monetary Authorities have renneged on their promise to raise interests rates multiple times in recent years, including recently when Janet Yellen said that the Fed would raise interest rates, but when their November meeting came around they did not. These sort or statements and renneging make the Fed un-credible to firms and as such they no longer take stock in what they are hearing. This could explain why the stock market has remained in pristine shape despite multiple statements from the Fed that they were going to raise interest rates. Since the market no longer believes the Fed, they continue on with business as usual. If the Fed was truly credible, talk about raising interest rates most likely would have impacted the stock market and investment without having even raised interest rates yet. To begin to be once again effective, the Fed should begin to re-establish credibility in the eyes of the market. The Fed’s “shocks” are no longer truly shocks as the market no longer believes the Fed.
When the Fed raises interest rates, they do so to discourage investment, which lowers aggregate demand and a drop in output (1). One would think investors and companies would respond negatively to this, but if the Fed is saying it’s acceptable to raise rates, they must believe the economy is in a good enough state where a rate increase is okay and helps to keep inflation and other factors from changing too much. It can be seen historically in the last time the Fed increased rates in December 2015 when the Fed raised rates from a range of 0% to 0.25% to a range of 0.25% to 0.50% (2). Companies and investors expected this increase and saw it as a sign of how well the economy had been doing since the Great Recession. This can be seen by how the DOW, S&P 500, and the Nasdaq all increased considerably following the announcement (3). This increase in rates also eased the fears that the Fed would be trapped at near-zero rates and another good showing of the strength of the economy. Overall an increase in interest rates by the Fed can be a good show of faith to investors and companies that the economy is thriving, however if raised too high or unexpectedly could send a negative shock throughout the market and lower aggregate demand. The Fed needs to be careful about what it really wants to accomplish and how it’s going to do it.
In the economy, an increase in money supply can have positive changes in output only if nominal interest is lowered, so that the cost of borrowing to consume and invest becomes cheaper, resulting in increase in consumption and investment. But how much a decrease in nominal interest rate changes output in the economy? As Mishkin points out, it is the “real” interest rate what really determines how much a decrease in nominal interest rate influence spending and therefore output. Firms and households taking out loans that must be repaid in the future will be likely to make the decision whether to borrow or not based on what they expect the inflation to be at the time they repay the loan. If they expect higher inflation, their real interest rate will decrease, which would leads to increase in borrowing. With nominal interest rate at a floor of zero and expansion in the money supply, expected prices in the future will likely to rise, and hence the expected inflation, thereby lowering the real interest rate [Mishkin, 1996]. However, Sharpe and Suarez mention that surveys shows that vast majority of CFO’s investment plans are insensitive to decrease in cost of borrowing; only 8% would increase investment if borrowing cost declines 100 points and another 8% to a decrease of 100 to a 200 points. Surprisingly, firms with higher growth expectations were found less sensitive to changes in interest rate [Sharpe and Suarez, 2014]. Another fact to consider that might not influence not only CFO’s investment plans but also households to borrow even at a low short-term interest rate is future expected real interest rate. If the public expects the central bank to follow the Taylor rule, it anticipates an interest rate hike as soon as there are inflationary pressures in excess of the implicit inflation target [Eggertsson and Woodford, 2003]. If individuals consider a monetary rule like the Taylor rule, which consist on determine the short-term interest rate based on the difference between current and target inflation, they will realize that once current inflation equals its long-run target, nominal interest rate will start to rise, leading to a decline in prices, which in turn will increase firm’s and consumers real interest rate because of the future lower expected inflation.
Basic economic theory suggests that when the Fed raises interest rates, investment and output decrease. However, Sharpe and Suarez find that this relationship does not seem to exist in recent years. After the 2015 raise in interest rates, stock prices largely increased, contrary to what this fundamental theory would suggest. Alternative types of monetary policy have also struggled to affect the overall economy during this time period. As shown by Fawley and Neely, Quantitative easing has increased the monetary base, but much of this has been held by banks as excess reserves. Thus, the impact to broader conceptions of money (M1,M2) was diminished.
Due to the difficulty of successfully impacting the larger economy via monetary policy in the low interest rate climate of recent years, some argue that the Fed should normalize monetary policy and return to higher interest rates. With higher interest rates, it is plausible that changes to interest rates and other types of monetary policy would begin to once again have a greater effect on the economy as a whole. However, in recent years the Fed has only raised interest rates by .25%, so it may be a while before this normalization process is completed.
Prior to the financial crisis of 2008, the primary way in which the Fed attempted to stimulate economic activity was by lowering the Federal Funds Rate or interbank lending rate. This policy change on interest takes affect through 4 main transmission channels. When these commercial interest rates fall, the cost of borrowing decreases and thus households & firms are more able to consume. As consumption rises, firms hire more workers in response which drives down unemployment rates. Changing interest rates also have an effect on asset prices such as bonds. As interest rates falls, the price of bonds will increase which in turn increases household wealth, theoretically should also increase consumption and borrowing. As interest rates fall the exchange rate falls contingent on the fact that domestic assets are less attractive to foreign capital. This depreciation in the dollar makes domestic goods cheaper, decreasing unemployment conditional to an increase in demand. The fourth channel in which the Fed can affect the market is by influencing expectations of long-term interest rates and inflation as these can affect market behaviors in the present.
However, in 2008 the Fed had to turn nontraditional methods of creating this economic activity since interest rates had reached near zero levels. In the fall of 2008 the FOMC used Open Market Operations by purchasing securities and other assets in an attempt to lower interest rates. Since this increases the money supply, interest rates should fall and stimulate economic growth. Despite the fact this policy differs from “traditional” policy, it still operated through the 4 transmission channels which made the policy effective. For now, the Fed can simply buy and sell these securities to control interest rates, but they have a long term plan to “normalize” their policy through shrinking the size of the balance sheet. The time it will take to shrink the balance sheet depends on the maturity rates of Mortgage Backed Securities – which are unpredictable – and Treasury Securities which are relatively predictable. Although this strategy of OMO works, the fed will be able to return to more “normalized” policy once they sell back these securities.
The Fed operates behind the idea that it can affect the overall economy by manipulating short-term interest rates. They do so by changing the short-term lending rate that it has between banks, directly affecting the nominal interest rate at which firms and households can borrow from commercial banks. The story follows that if the Fed lowers the nominal interest rate firms and households will decide to borrow more and therefore spend more, boosting aggregate demand. If the Fed announces policies to lower the nominal interest rate, consumers expect future interest rates to be lower so there is an incentive to spend now because the benefit of saving for the future has decreased. However, recent attempts at changing aggregate demand and achieving a desired inflation rate through the interest rate channel has had disappointing results.
A significant part of our financial system isn’t banks. Other things like hedge funds or money market mutual funds have an important role in the financial system, and the interest rate channel only affects certain banks. The lack of results from using the interest rate channel has led the Fed to explore other ways in which it can affect aggregate demand, particularly the repo market. A repo market is where a bank exchanges bonds for cash with another bank. A bank uses the repo market when they are looking to make a loan, but don’t have the cash to do so. The idea is that the bank makes a loan to a firm or household, expecting to get repaid the loan plus whatever interest it earned. Then then bank buys off the bonds it originally exchanged at a slightly higher price than it sold it at. In the end, both institutions end up with more reserves than they started with. If the Fed feels that banks are giving out too many loans at generous rates, the Fed will intervene in the repo market. Once a bank has exchanged its bonds for cash from another bank, instead of having the bank give out a loan to a firm, the Fed offers to borrow that money in exchange for treasuries which it will buy back off the bank at an interest rate greater or equal to the interest rate the bank was ready to offer the consumer. Through this method it is believed the Fed can more efficiently affect the nominal interest rate that financial institutions offer their customers other than commercial banks.