Does the recent low interest rate induce more investment?

As Keynes argued that the solution to the Great Depression was to create more investment through a reduction in interest rates, one of the goals the Fed pursued through its near zero interest rate policy was to lower overall interest rate in the economy and create more investment. As we studied from IS-LM model, I(nvestment) part of the model is a decreasing function of the real interest rate. But, of course, IS-LM model is very simplified but useful to see effects of certain changes in the economy isolated from other factors. If we naively assume the model’s argument and recent economic condition since the recession, we would expect total investments to be risen since the Fed has shifted to zero interest rate policy. As the monetary policy makers lowered the interest rate to near zero, the economy has been seeing the only period of below zero real interest rate which wasn’t created by high inflation as it was in the 1970’s.

Historical real interest rate ( 10 year rate minus personal consumption expenditure inflation rate)

Historical real interest rate ( 10-year rate minus personal consumption expenditure inflation rate)

We would expect businesses to borrow money with negative real interest rate and invest it to their businesses, right? Recent research done by by Federal Reserve staff economists Steve Sharpe and Gustavo Suarez showed that businesses investors were inelastic to low interest rates. According to the paper,

The vast majority of CFOs indicate that their investment plans are quite insensitive to potential decreases in their borrowing costs. Only 8% of firms would increase investment if borrowing costs declined 100 basis points, and an additional 8% would respond to a decrease of 100 to 200 basis points.

Strikingly, 68% did not expect any decline in interest rates would induce more investment.

In addition, we find that firms expect to be somewhat more sensitive to an increase in interest rates. Still, only 16% of firms would reduce investment in response to a 100 basis point increase, and another 15% would respond to an increase of 100 to 200 basis points.

Read more: http://www.businessinsider.com/business-investment-sensitivity-to-interest-rates-2014-1#ixzz2qXqvjHoN

In other words, one of the goals, namely to increase investment, that the policy makers hoped to achieve through the low interest rate policy hasn’t been achieved.

Private non-residential fixed investment, federal funds rate, and real interest rate

Private non-residential fixed investment, federal funds rate, and real interest rate

If we look at the above graph, business sector hasn’t been really responding to the historically low real interest rate. It may be due to the uncertainty created by the Fed’s policy tools.

Overall, total real private investment hasn’t gotten back to a level it was at before the recession.

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This slow increase in private investment has been one of the reasons the recovery has been slow since the recession. The Fed should increase the business and consumers confidence to increase investment.

 

4 thoughts on “Does the recent low interest rate induce more investment?

  1. nickcoll

    I think also a lot has to do with banks sitting on cash reserves instead of loaning it out. Due to low interest rates, banks have a decreased incentive to create new loans when the returns on these loans are going to be very small.

    1. enjar Post author

      Yeah good catch! I forgot to mention that. That interest on the reserve policy makes little sense as the Fed wants their policy to be more effective.

  2. viczhou

    I do enjoy the fact that you applied economic theories into real-life issues. Theoretically, record-low interest rates were expected to boost investment significantly, but as you pointed out, it was due to uncertainties of fed’s policy and pessimistic economic outlook that investors were kind of inelastic to low rates. Good job!

  3. mhupp

    Wow, this has really been a one-sided discussion so far, huh? Time to shake things up a bit. I think that what we should keep in mind here is that we’re interested in counterfactuals. The question is not so much: did the federal funds rate and actual aggregate investment move in tandem? The question is: what would have happened to aggregate investment had the Fed not intervened at all? And neither the paper nor the graph can address this, because you’d need a fairly sophisticated econometric analysis to be able to answer that question. What I’m saying is that while private investment decreased during the crisis, it might have bottomed out at a much lower level without a Fed intervention.
    Another thing is that the Fed couldn’t push its nominal funds rate below zero. That’s a problem central banks will run into whenever they operate using inflation targets that are too low to cope with a truly severe adverse shock. A further reduction in interest rates could have had an even stronger effect than the actual zero rates we saw (and still see).
    Lastly, the authors of that paper didn’t really ask, “do you ignore the interest rate you have to pay on loans when making investment decisions?” Instead, they simply asked people whether in their current situation, they’d react to certain changes in the interest rate. And a 100 basis points change of the effective rate facing firms isn’t the same as a 100 basis points change in the federal funds rate. Because this is being intermediated by banks, the rate facing firms will be higher than the Fed’s rate. A 100 basis point increase in the effective rate can actually correspond to a change in the federal funds rate that’s substantially below 100 basis points.
    And one final thought on discouraging investment through low interest rates and interest on reserves. A low federal funds rate as such shouldn’t discourage bank investment. It should simply shift it towards more profitable projects, i.e. funding firms’ investment through loans. These are still going to earn an interest rate that’s substantially above zero. Also, the interest on reserves is a policy in and of itself. It was lowered during the crisis to discourage banks from sitting on their reserves. It will be increased once the economy actually gets going again to prevent overheating. There was a discussion about having negative interest on reserves, but that’s usually not feasible so long as banks could – theoretically – hoard cash instead. Certain assets did actually have negative real rates during the crisis, though, so even negative rates may not be such a horrible idea if you can do something about the cash access of large banks.

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