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Interest rates do not seem to affect investment as economists assume
Oct 18th 2014 | New York | From the print edition
IT IS Economics 101. If central bankers want to spur economic activity, they
cut interest rates. If they want to dampen it, they raise them. The assumption
is that, as it becomes cheaper or more expensive for businesses and households
to borrow, they will adjust their spending accordingly. But for businesses in
America, at least, a new study* suggests that the accepted wisdom on monetary
policy is broadly (but not entirely) wrong.
Using data stretching back to 1952, the paper concludes that market interest
rates, which central banks aim to influence when they set their policy rates,
play some role in how much firms invest, but not much. Other factors most
notably how profitable a firm is and how well its shares do are far more
important (see chart). A government that wants to pep up the economy, says S.P.
Kothari of the Sloan School of Management, one of the authors, would have more
luck with other measures, such as lower taxes or less onerous regulation.
Establishing what drives business investment is difficult, not least because it
expands and contracts far more dramatically than the economy as a whole. These
shifts were particularly manic in the late 1950s (both up and down), mid-1960s
(up), and 2000s (down, up, then down again). Overall, investment has been in
slight decline since the early 1980s.
Having sifted through decades of data, however, the authors conclude that
neither volatility in the financial markets nor credit-default swaps, a measure
of corporate credit risk that tends to influence the rates firms pay, has much
impact. In fact, investment often rises when interest rates go up and
volatility increases.
Investment grows most quickly, though, in response to a surge in profits and
drops with bad news. These ups and downs suggest shifts in investment go too
far and are often ill-timed. At any rate, they do little good: big cuts can
substantially boost profits, but only briefly; big increases in investment
slightly decrease profits.
Companies, Mr Kothari says, tend to dwell too much on recent experience when
deciding how much to invest and too little on how changing circumstances may
affect future returns. This is particularly true in difficult times. Appealing
opportunities may exist, and they may be all the more attractive because of low
interest rates. That should matter but the data suggest it does not.