At Barron’s: Do Interest Rates Really Drive the Economy?

(I write a more-or-less monthly opinion piece for Barron’s. This is my contribution for March 2023; you can find the earlier ones here.)

When interest rates go up, businesses spend less on new buildings and equipment. Right?

That’s how it’s supposed to work, anyway. To be worth doing, after all, a project has to return more than the cost of financing it. Since capital expenditure is often funded with debt, the hurdle rate, or minimum return, for capital spending ought to go up and down with the interest rate. In textbook accounts of monetary policy, this is a critical step in turning rate increases into slower activity.

Real economies don’t always match the textbook, though. One problem: market interest rates don’t always follow the Federal Reserve. Another, perhaps even more serious problem, is that changes in interest rates may not matter much for capital spending.

A fascinating new study raises new doubts about how much of a role interest rates play in business investment.

To clarify the interest-investment link, Niels Gormsen and Kilian Huber — both professors at the University of Chicago Booth School of Business — did something unusual for economists. Instead of relying on economic theory, they listened to what businesses themselves say. Specifically, they (or their research assistants) went through the transcripts of thousands of earnings calls with analysts, and flagged any mention of the hurdle rate or required return on new capital projects. 

What they found was that quoted hurdle rates were consistently quite high — typically in the 15-20% range, and often higher. They also bore no relationship to current interest rates. The federal funds rate fell from 5.25% in mid-2007 to zero by the end of 2008, and remained there through 2015. But you’d never guess it from the hurdle rates reported to analysts. Required returns on new projects were sharply elevated over 2008-2011 (while the Fed’s rate was already at zero) and remained above their mid-2000s level as late as 2015. The same lack of relationship between interest rates and investment spending is found at the level of individual firms, suggesting, in Gormsen and Huber’s words, that “fluctuations in the financial cost of capital are largely irrelevant for [business] investment.”

While this picture offers a striking rejection of the conventional view of interest rates and investment spending, it’s consistent with other research on how managers make investment decisions. These typically find that changes in the interest rate play little or no role in capital spending. 

If businesses don’t look at interest rates when making investment decisions, what do they look at? The obvious answer is demand. After all, low interest rates are not much of an incentive to increase capacity if existing capacity is not being used. In practice, business investment seems to depend much more on demand growth than on the cost of capital. 

(The big exception is housing. Demand matters here too, of course, but interest rates also have a clear and direct effect, both because the ultimate buyers of the house will need a mortgage, and because builders themselves are more dependent on debt financing than most businesses are. If the Fed set the total number of housing permits to be issued across the country instead of a benchmark interest rate, the effects of routine monetary policy might not look that different.)

If business investment spending is insensitive to interest rates, but does respond to demand, that has implications for more than the transmission of monetary policy. It helps explain both why growth is so steady most of the time, and why it can abruptly stall out. 

As long as demand is growing, business investment spending won’t be very sensitive to interest rates or other prices. And that spending in turn sustains demand. When one business carries out a capital project, that creates demand for other businesses, encouraging them to expand as well. This creates further demand growth in turn, and more capital spending. This virtuous cycle helps explain why economic booms can continue in the face of all kinds of adverse shocks — including, sometimes, efforts by the Fed to cut them off.

On the other hand, once demand falls, investment spending will fall even more steeply. Then the virtuous cycle turns into a vicious one. It’s hard to convince businesses to resume capital spending when existing capacity is sitting idle. Each choice to hold back on investment, while individually rational, contributes to an environment where investment looks like a bad idea. 

This interplay between business investment and demand was an important part of Joseph Schumpeter’s theory of business cycles. It played a critical role in John Maynard Keynes’ analysis of the Great Depression. Under the label multiplier-accelerator models, it was developed by economists in the decades after World War II. (The multiplier is the link from investment to demand, while the accelerator is the link from demand growth to investment.) These theories have since fallen out of fashion among economists. But as the Gormsen and Huber study suggests, they may fit the facts better than today’s models that give decisive importance to the interest rate controlled by the Fed.

Indeed, we may have exaggerated the role played in business cycles not just of monetary policy, but of money and finance in general. The instability that matters most may be in the real economy. The Fed worries a great deal about the danger that expectations of higher inflation may become self-confirming. But expectations about real activity can also become unanchored, with even greater consequences. Just look at the “jobless recoveries” that followed each of the three pre-pandemic recessions. Weak demand remained stubbornly locked in place, even as the Fed did everything it could to reignite growth.

In the exceptionally strong post-pandemic recovery, the Fed has so far been unable to disrupt the positive feedback between rising incomes and capital spending. Despite the rate hikes, labor markets remain tighter than any time in the past 20 years, if not the past 50. Growth in nonresidential investment remains fairly strong. Housing starts have fallen sharply since rates began rising, but construction employment has not – at least not yet. The National Federation of Independent Business’s survey of small business owners gives a sharply contradictory picture. Most of the respondents describe this as a very poor moment for expansion, yet a large proportion say that they themselves plan to expand and increase hiring. Presumably at some point this gap between what business owners are saying and what they are doing is going to close – one way or the other. 

If investment responded strongly to interest rates, it might be possible for the Fed to precisely steer the economy, boosting demand a little when it’s weak, cooling it off when it gets too hot. But in a world where investment and demand respond mainly to each other, there’s less room for fine-tuning. Rather than a thermostat that can be turned up or down a degree or two, it might be closer to the truth to say that the economy has just two settings: boom and bust.

At its most recent meeting, the Fed’s forecast was for the unemployment rate to rise one point over the next year, and then stabilize. Anything is possible, of course. But in the seven decades since World War Two, there is no precedent for this. Every increase in the unemployment rate of a half a point has been followed by a substantial further rise, usually of two points or more, and a recession. (A version of this pattern is known as the Sahm rule.) Maybe we will have a soft landing this time. But it would be the first one.