The Intricate Relationship Between Interest Rates and the Economy: Examining the Key Factors
The Surprising Truth About Interest Rates and Business Investment: Why Lowering Rates Might Not Boost the Economy
It’s commonly believed that when the Federal Reserve lowers interest rates, businesses will spend on new buildings and equipment. But according to a new study by economists at the University of Chicago Booth School of Business, the link between interest rates and investment spending might not be as strong as we thought.
Instead of relying on economic theory, the study by Niels Gormsen and Kilian Huber looked at what businesses themselves say. Analyzing the earnings call transcripts with analysts, they found that businesses’ quoted hurdle rates for new projects were consistently high, typically in the 15-20% range, and often higher. They also found that these hurdle rates bore no relationship to current interest rates. Despite interest rates being near zero for years, required returns on new projects were sharply elevated, suggesting that fluctuations in the financial cost of capital are largely irrelevant to business investment.
What Do Businesses Look at Instead?
If businesses don’t look at interest rates when making investment decisions, what do they look at? The answer is demand. While low-interest rates are not much of an incentive to increase capacity if existing capacity is not used, demand growth is a huge factor in business investment decisions. In other words, businesses are more likely to invest in new projects if they anticipate increasing demand for their products or services.
The Exception: Housing
The exception to this rule is housing. While demand still matters for housing, interest rates have a clear and direct effect. This is because the buyers of the house will need a mortgage, and builders themselves are more dependent on debt financing than most businesses.
- Low-interest rates can hurt businesses that rely on income from interest-bearing investments, such as retirees or insurance companies.
- Business investment tends to be more sensitive to changes in tax policy than interest rates.
- Technological innovations and changes in global trade also influence business investment.
The notion that lowering interest rates will automatically boost the economy might not be accurate. While it might make borrowing cheaper, businesses are more likely to invest in new projects if they anticipate increased demand for their products or services. As such, policymakers should consider various factors when deciding on monetary policy and economic stimulus.
The study by Niels Gormsen and Kilian Huber challenges conventional wisdom about the relationship between interest rates and business investment. While businesses’ quoted hurdle rates for new projects were consistently high, they bore no relationship to current interest rates. Instead, businesses are more likely to invest in new projects if they anticipate increased demand for their products or services. Policymakers should be aware of this when making decisions about monetary policy and economic stimulus.