Monetary policy: overrated
But a recent study on aggregate corporate investment could make policymakers squirm: It posits that, at least in the US, the impact of interest rates on business investment is much weaker than the conventional wisdom would have it. Drawing on aggregate corporate investment data from 1952-2010, the authors find that expected investment growth is tightly linked to changes in profits and stock prices, but only weakly related to changes in interest rates and the default spread on corporate bonds. Moreover, the study finds no evidence that investment growth slows down after a rise in short-term or long-term interest rates, a finding that contradicts the idea that central bank-driven movements in interest rates are a main driver of corporate investment.
The research findings seem to resonate with recent history: Despite historically low interest rates, business capital expenditure has shown only a limited uptick. As it turns out, it is not interest rates but profits and stock prices that are the best predictors of corporate investment. Based on the report data, a $1 increase in profits leads to a $0.25 increase in investment in the subsequent fiscal quarter, and nearly $1 over five quarters. Meanwhile a 10% increase in stock prices leads to a cumulative 4.3% rise in investment over the subsequent 18 months. These findings suggest that companies’ investment decisions are driven by their profit outlook and the general economic and business environment. The study also suggests, perhaps unsurprisingly, that investment activity is strongly procyclical.
The authors also considered the power of policymakers to ascertain the extent to which tight credit markets affected business investment during the recent recession. Using GDP, profits, and stock data alone, they modelled the level of investment activity that would have been expected during the recession. Although corporate investment in the US plummeted by 27% between 2007 and 2009, the bulk of the decline “looks like a historically typical response to macroeconomic conditions, even without any unusual behaviour in the banking sector and credit markets.” The report concludes that blaming the banks for credit drought seemed misplaced: “Although problems in the credit markets may have played a role, the impact on corporate investment is arguably small relative to the decline in investment opportunities.”
The policy implications of this research are drastic. As corporate investment is clearly an engine of growth, it is vitally important for policymakers to understand what drives it, and at the very least, the research should be replicated in the UK and other advanced economies. If the cost of capital is shown not to be a major driving factor in investment decisions, then policymakers should focus on the variables that really do get companies excited about investing. S. P. Kothari, one of the authors of the report, states that first and foremost, policymakers should focus on the investment climate, which is driven by factors like tax rates, regulation, and labour market conditions. These are the key factors that make investment attractive or less attractive. Moving the interest rate by one or two percentage points does not generate a change in investment behaviour.