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.
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.
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.
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.
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.