New research: interest rate cuts don’t shift corporate investment
MIT professor dispels conventional wisdom about how and when companies decide to spend
August 1, 2014
Deputy Dean S.P. Kothari
Policymakers fret constantly about how to spur companies to create jobs. One of the most powerful levers toward that end—in theory—is interest rates. Lower interest rates, the logic goes, and capital becomes cheaper, prompting companies to invest more now, ultimately leading to higher production and more jobs. That notion is central to the low interest rate environment the Federal Reserve has promoted in recent years; a policy that Federal Reserve chair Janet Yellen is currently hinting will continue until jobs growth picks up.
In a new paper, MIT Sloan deputy dean and accounting professor S.P. Kothari has a revelation for Yellen and her colleagues: The longstanding belief that lower interest rates propel capital expenditures is incorrect. The upshot, Kothari says, is stop expecting interest rates to do the trick.
Based on nearly 60 years of data, “what we find is that moving the interest rate by one or two percent does not generate a change in investment behavior on the part of corporations,” says Kothari.
That surprising finding is just one of several unexpected trends that Kothari and his co-authors Jonathan Lewellen of the Tuck School of Business at Dartmouth College and Jerold B. Warner at the University of Rochester’s Simon School of Business uncovered in a working paper titled “The behavior of aggregate corporate investment.” The trio set out to address a question that looms large: what drives corporate investment in the form of capital expenditures? While some factors seem obvious—including interest rates—the challenge was to distill the ones that have the most impact from those that may be merely coincidental.
“Corporate investment is the engine of growth, so it’s critically important to understand what gets corporations excited about investing,” Kothari says.
In search of answers, Kothari and his co-authors compare the Federal Reserve’s Flow of Funds quarterly corporate investment data against the changes in profits, stock prices, volatility, short-term and long-term interest rates and other factors over the period between 1952 and 2010. When they isolate the effect of interest rate changes on corporate investment, they find that the two have virtually no consistent relationship. Low interest rates didn’t spur corporations to invest, nor did high rates seem to inhibit them from investing, suggesting that “cheap” outside capital is of limited importance in investment decisions. (Interest rates weren’t the only variable to drop out of the equation: Kothari and his colleagues find that market volatility also has little relation to corporate investments, despite conventional wisdom.)
Kothari notes that, while unexpected, the finding resonates with recent history, in which corporate capital expenditures have barely grown despite the historically low interest rates. “It seems to explain the inability of the Fed to really stimulate investment over the past five to six years,” he says.
So what does get corporate executives excited about investing? It turns out that healthy profits and stock prices are the strongest predictors of corporate investment. A $1 increase in profits, for example, leads to a 25 cent increase in investment the following quarter, and nearly $1 over five quarters. Meanwhile, a 10 percent increase in stock prices predicts a cumulative 4.3 percent rise in investment over the subsequent 18 months.
“What corporations really respond to is what sort of profit outlook they face, and the general environment for growth,” Kothari says, noting that investment also closely correlates with gross domestic product growth.
Practically speaking, the results make sense in that companies have more money to invest, more investment opportunities, and more pressure to spend from investors when things are good; all those factors dry up when the economy slows down.
The ability to predict corporate investment with those variables led the economists to a second question related to the power of policymakers: to what extent did the tight credit markets affect investment during the financial crisis and related recession? In the moment, it seemed clear that the dearth of lending was a big problem. In hindsight, however, blaming the banks for the credit drought seems misplaced.
Kothari and his colleagues model how much investment would have been expected during the recession, based on GDP, profits, and stock data alone. What they find is that although corporate investment did experience an unprecedented 27 percent decline between 2007 and 2009, “the bulk of the decline looks like a historically typical response to macroeconomic conditions, even without any unusual behavior in the banking sector and credit markets,” they write in the paper. While “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” during the period.
Policymakers aren’t the only ones who might squirm when they read Kothari’s paper, however. The research reveals that corporate executives have their own foibles, including a propensity to overinvest at exactly the worst time in the economic cycle. While profits and stock prices rise before a spike in corporate investment, both decline almost immediately afterward.
“Rational economic theories suggest more investment would be greeted by stronger profits and higher stock returns,” says Kothari. (Since capital expenditures are deducted from revenues over a long period of time, the investment itself does not immediately reduce profits.) Instead, profits drop by roughly 70 cents per dollar of increased capital spending in the three to six months following the investment.
The economists puzzle out loud in the paper about why large increases in investment would precede such drops in profits and stock prices. While in some cases the investment itself could spark higher costs that drag down profits—a company that builds a new factory may then have to hire more labor to make it operational, for example—or the subsequent drops could be a sign of industry disruptions, the authors discount both ideas based on the fact that those stresses should be longer lasting than the effects they observe.
The main reason for the negative relationship between capital expenditure spikes and business performance, Kothari believes, is a behavioral: irrational exuberance. “As stocks and profits go up, corporations keep investing,” he says. “But rather than stopping at an appropriate point in time, they go a bit too far. If they had stopped at the right point, it could have been great.”
How can executives overcome this bias? CEOs and CFOs “should temper their outlook based on the evidence that glorious past performance doesn’t continue indefinitely,” he says. “It doesn’t mean they have to turn off the spigot completely; it’s slight moderation, maybe investing $900 instead of $1000.”
The takeaway for policymakers is somewhat more drastic. “First and foremost, they should focus on the investment climate, which is driven by things like tax rates, regulation, and labor reforms,” Kothari says. “Those are the factors that make the investment decisions attractive or less attractive for managers, so that’s where the dial should be turned.”