Home > Macro/Monetary Theory, Uncategorized > Does Tighter Monetary Policy Increase Investment?

Does Tighter Monetary Policy Increase Investment?

I came across a short piece recently citing a former New York Fed economist entitled Tighter Fed Policy Will Boost Economy.  I was pretty taken aback by this and I’ve been trying to wrap my mind around it.  I couldn’t find he actual report (it may be an internal UBS document or a clients-only sort of thing) and the press release I am going on is pretty brief so I have to guess a little bit as to what Matus has in mind.  It’s also worth noting that he is not quoted in the body using the word “tightening” so it’s possible the headline writer is more confused than Matus.  But whatever his reasoning, it provides a pretext for an attempt to explain why looking at monetary policy through an interest-rate lens is potentially misleading.

There are two issues here.  One is the question: what is tightening?  The other is: do low rates cause more or less investment?  To answer the first, we have to consider the second and see that it is not really a coherent question.

On the surface, conventional wisdom tells us that low rates lead to more investment.  This is the story behind the Keynesian IS-LM model taught in intermediate macro classes.  The CB increases the money supply which causes interest rates to fall (shifting the LM curve to the right) and the lower rates increase investment which increases output (moving along the IS curve).  In the context of that model, this is what we would call monetary “easing.”  Note that whether you look at this as an increase in the money supply or a decrease in interest rates is purely semantic as I try to explain here.

Yet, here is an economist claiming that higher rates will lead to more investment.  How is that possible?  The short answer is that this is “reasoning from a price change” which is a cardinal sin of economics but which is nearly impossible to avoid if you are thinking about policy in terms of interest rates.

Interest Rates and Investment

It makes no sense to try to determine the effect of a change in the price of coffee on the quantity of coffee beans exchanged.  But we constantly talk about changes in the interest rate “causing” changes in investment or consumption etc.  This is a sort of conundrum created by the central bank saying that they are fixing the interest rate exogenously as a matter of policy.  They can do this because they can control the quantity of money and the nominal rate is the price of money (in a sense at least).  But even if you take the nominal rate to be exogenous, you still don’t know the cost of investment because the cost of investment is the real rate which is the nominal rate minus the expected rate of inflation.

If you are deciding whether to invest in a new factory, your decision depends on whether or not the (net) present value of the produce of the factory in the future will be more than the cost of building it.  The lower the nominal rate, the more these future values will have to be discounted, or to say it another way, the more interest you will have to pay on the loan (or forego on the money) that it takes to build it.  But the higher the expected rate of inflation, the higher those future values will be.  So if the nominal rate changes, the effect depends on why it changes.

The simplest way to get to the Keynesian result above, is to imagine that expected inflation is fixed and doesn’t change when the CB “lowers the interest rate.”  In this case, the real rate will also fall and investments that were not appealing before will become viable.  Alternatively, if inflation expectations suddenly increase and the CB does not allow nominal rates to increase as much, you also have the real rate decreasing which should also increase investment.

In the latter case, you would see nominal rates rising along with investment.  And if you only judged the stance of monetary policy by the nominal interest rate, you might conclude that “tightening” was causing an increase in investment.  However, this is not a good way to think about monetary policy because the higher rates would be the result of a more expansionary monetary policy.  I can’t think of a possible explanation for thinking that “tighter” monetary policy would cause increased investment unless all that one means by “tighter monetary policy” is higher nominal rates.  In which case, as Scott Sumner likes to remind us, Weimar Germany had incredibly tight monetary policy.

The most confusing thing in the article was this statement.

‘The expectation for rising rates may prove helpful,” said Matus. “Low rates not only lower the cost of delaying investment decisions but also encourage other behavior that can be detrimental to business investment.’

In periods of low rates, equity investors usually favor companies that buy back shares and pay dividends, said Matus. That encourages chief executive officers to use cash in those ways, rather than invest in new plants or machinery.

The first part about “lowering the cost of delaying investment decisions” makes no sense to me.  Low nominal rates (holding inflation expectations constant) means lower cost of investment.  There is a cost and a benefit to investment and we expect businesses to invest when they think the benefit is greater than the cost.  Are executives sitting in boardrooms saying “we want to delay some investment but we’re not sure how long to delay it, what are the costs and benefits?”  Even if they were, wouldn’t the cost of delaying it be lower with higher nominal rates?  You would make more on your “cash” reserves (which I believe is typically not technically cash) in the meantime (or pay less on loans).  This seems like pure carelessness to me but seemingly this guy is getting paid to figure this stuff out and I can’t say the same, so maybe I am missing something.

But putting that aside, is it true that investors favor companies that buy back shares and pay dividends when interest rates are low?  That doesn’t seem like what we have been observing lately.  In fact, we have seen a plethora of “growth” stocks with little to no earnings skyrocket in price relative to broader market averages over the last couple years.  It’s true that may larger-cap stocks have increased dividends and buybacks, and some others, like Apple, have been under pressure to do so from activist investors.  But is this really a sign that investors are demanding less investment?  I don’t think so.  Here is an alternative story.

Companies each have access to some set of investment opportunities and some amount of cash/credit, the cost of which is the nominal interest rate.  The nominal return on their investment opportunities is given by the real rate of return plus the expected inflation rate.  Companies invest until the marginal real rate of return on investment is equal to the real interest rate.  When the real rate is lower, it makes more investments look profitable.

Now assume that the low real rates are accompanied by an influx of cash into the economy.  But because different companies have access to different investment opportunities, the ones who accumulate this cash may not be the ones with the optimal investment opportunities.  For instance, imagine that one company, let’s call it “Tesla,” happens to have the ability to invest a large amount of money and return 2% in real terms, while the real interest rate is 0%.  And let’s say that there is another company, call it “Apple,” that is accumulating a lot of cash on its balance sheet but is already investing in all the projects available to it with a positive real rate of return.

Now if you are an investor sitting on a big pile of cash, and just to make things a little cleaner, let’s assume that you have access to a secondary offering of each company at book value, which one do you want to invest in?  The answer should be clear, you want the one which will earn a higher return on the money you invest.  This means that the companies with the best investment opportunities will attract more capital.  Conversely, if you own Apple, and they are sitting on a pile of “cash” which is earning no interest and which they have no productive use for, you will want them to give you that cash so that you can divert it to a company with better investment opportunities.

Another way of coming at the same idea is to say that, if both companies are trading at the same premium to book value, people will want to “rotate” into the high-growth companies which will cause them to trade at a higher premium.  The companies with a lot of cash, in the face of this rotation away from them, may start throwing off that cash in the form of dividends and buybacks to increase their dividend yields and prop up their stock prices.

The same logic can be applied to mergers and acquisitions.  If Apple has a lot of cash and no good investments and Tesla has good investments but not cash, instead of returning cash to shareholders and letting them invest it in Tesla, Apple can just cut out the middle man and buy Tesla itself.  But none of this is evidence that low interest rates are causing companies to invest less in aggregate.  It is just evidence that cash has to move around to find the best investments.  That, after all, is basically the whole point of equity markets.

Interest Rates and the Stance of Monetary Policy

Hopefully we can agree that the lower nominal rates, all other things (including inflation) equal, the more incentive to invest there is.  Similarly, the higher expected inflation is, all other things (including nominal rates) equal, the more incentive to invest there is.

This is not that difficult to understand, but the problem comes in when you insist on seeing rising interest rates as “tightening” (or for that matter, on seeing “tightening” as rising interest rates).  But when you step outside of that mindset, things get a little complicated.  This is because, nominal rates and inflation are both components of monetary policy and they are not independent.  In order to generate more inflation, the CB has to increase the money supply.  And if you see monetary policy as just setting an interest rate, the only way to increase the money supply is by lowering the rate.  So you find yourself having to say that they are trying to raise interest rates by lowering interest rates.  Is that easing or tightening?

The simplest way around this is to think in terms of the quantity of money instead.  Then you can just say that “easing” means expanding the money supply which lowers nominal rates (and increases investment) in the short run but increases inflation and has an ambiguous effect on long-term nominal rates.  Of course, if we all did that, then we would dramatically reduce the demand for confused debates about the effect of interest rates on stock prices and investment.  And nobody wants that.

 

 

 

 

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