Monday, May 8, 2017

Do interest rates matter?

Central bank rate cycles have become the pivot around which economic discussions converge. But is this perceived central role reflected in the actions of economic agents? In other words, do businesses respond to rate cuts with increased investments and vice-versa? Do their hurdle rates change in response to rate changes? The historical evidence on the inverse relationship between interest rate and investment changes have been mixed.

A 2014 Federal Reserve of Washington paper that did a cross-sectional analysis of the findings of the Global Business Outlook Survey conducted in the second quarter of 2012 found that,
Most firms did not see themselves as likely to increase investment if interest rates decreased. Firms expected to be somewhat more sensitive to interest rate increases than decreases, but for the most part the interest rate increases required to elicit adjustments to investment plans are generally quite large. The investment plans of firms that do not expect to borrow over the coming year or for firms that do not report that working capital management as one of their top business concerns tend to be less sensitive to interest rate changes than the average sample firm. More surprisingly, we find that firms that expect stronger growth in revenue— presumably firms with brighter investment opportunities—also tend to be less sensitive to interest rates. We interpret this finding as suggesting that faster growing firms face marginal investment returns that substantially exceed the cost of borrowing. Separately, we provide evidence from other business surveys conducted over the past few decades which indicates that, in contrast to steeply declining interest rates, average hurdle rates have remained elevated and quite steady over that period. This seems to corroborate our main finding that investment plans tend to be quite insensitive to interest rates.
A Reserve Bank of Australia paper too comes to the same conclusion,
Firms typically evaluate investment opportunities by calculating expected rates of return and the payback period (the time taken to recoup the capital outlay). Liaison and survey evidence indicate that Australian firms tend to require expected returns on capital expenditure to exceed high ‘hurdle rates’ of return that are often well above the cost of capital and do not change very often. In addition, many firms require the investment outlay to be recouped within a few years, requiring even greater implied rates of return. As a consequence, the capital expenditure decisions of many Australian firms are not directly sensitive to changes in interest rates. Furthermore, although both the hurdle rate of return and the payback period offer an objective decision rule on which to base expenditure decisions, the overall decision process is often highly subjective, so that ‘animal spirits’ can play a significant role. 
The last point about 'animal spirits' highlights an important distinction. 

Interest rate transmission has two channels. One, a direct response, whereby a cut in rates lowers the cost of borrowing and therefore increases the attraction of investing. In a world where rate changes in a cycle nowadays, at least in the major economies, are likely to be no more than 2-3 percentage points, often lowered in small increments of 25 basis points that further diffuses their impact, it is not surprising that the direct channel is weak.

The second is an indirect response channel where rate cuts, when combined with other trends perceived as favourable, boost 'animal spirits', which again increases the attraction of investing. However, 'animal spirits' are not a function of just interest rate cuts, especially when the rate cuts are small. They require a confluence of other, most often much more proximate and structural, factors perceived as favourable to economic growth. Small rate changes are more likely to be marginal contributors to the generation of 'animal spirits'. 

So we have two weak channels for monetary policy influence on investment decisions. This raises more questions about the appropriateness of the current out-sized importance of central banking in these economies. This assumes even greater significance given the now well acknowledged (the work of BIS economists in particular) role of monetary policy actions in engendering market distortions and widening inequality. 

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