Interest Rates And Investment Sensitivity: What's The Deal?

Interest rates are widely considered to be a critical determinant of business investment expenditures. However, there is mixed evidence for substantial interest-rate effects on investment. For example, firms with no near-term plans to borrow tend to be less sensitive to interest rate changes. In addition, investment is less interest-rate sensitive at firms expecting higher year-ahead growth. This article will explore why investment is not more sensitive to interest rates.

Insensitivity to interest rate changes is most pronounced among firms that do not indicate financial constraints as a top concern

Firms with no near-term plans to borrow tend to have higher hurdle rates, suggesting a possible connection between interest rate insensitivity and high hurdle rates. Hurdle rates are the minimum rate of return on a project or investment and have hovered near 15% for decades, despite the downward trend in market interest rates.

Firms expecting higher year-ahead growth also tend to be less sensitive to interest rate changes. This may be because these firms have higher hurdle rates, which are the minimum rate of return on a project or investment.

Overall, the insensitivity of investment to interest rate changes may be due to a variety of factors, including firms' financial constraints, near-term plans, and expectations for future growth.

Firms with no near-term plans to borrow are less sensitive to interest rate changes

Firms that are expecting higher growth in the following year are also less sensitive to interest rate changes. This may be because they have higher hurdle rates, which are the minimum rates of return that a firm requires to make an investment. The connection between high hurdle rates and interest rate insensitivity suggests that these firms are less likely to be influenced by interest rates when making investment decisions.

Overall, the sensitivity of investment plans to interest rates is mixed. While some firms may be more responsive to interest rate increases, others may not be affected by changes in interest rates at all. This could be due to a variety of factors, such as the firm's financial health, cash flow, and growth expectations.

Firms expecting higher year-ahead growth are less sensitive to interest rate changes

Investment is less sensitive to interest rate changes at firms expecting higher year-ahead growth. This is because these firms tend to have higher "hurdle rates", which are the rates firms report using to make new investment decisions. The average reported hurdle rate has been around 15% for decades, despite the downward trend in market interest rates. This suggests that firms with higher hurdle rates are less sensitive to interest rate changes.

Firms with higher hurdle rates may be less sensitive to interest rate changes because they have different investment goals or strategies. For example, they may be focused on long-term growth rather than short-term gains. Alternatively, they may have access to alternative sources of financing, such as ample cash reserves or low-interest debt, which makes them less dependent on market interest rates.

Additionally, firms that do not indicate financial constraints as a top concern and firms with no near-term plans to borrow tend to be less sensitive to interest rate changes. This may be because these firms have stable financial positions and do not rely heavily on external financing, making them less vulnerable to changes in market conditions.

It is worth noting that most firms claim their investment plans are quite insensitive to decreases in interest rates, but somewhat more responsive to interest rate increases. This suggests that firms may be more cautious about taking on new investments when interest rates are rising, as it could increase their financial risk.

Overall, the sensitivity of investment to interest rate changes varies across firms and is influenced by a range of factors, including hurdle rates, financial constraints, and borrowing plans. While interest rates are a critical determinant of business investment expenditures according to traditional theories, empirical research suggests that the relationship between interest rates and investment is complex and influenced by a variety of factors.

Ample cash or low-interest rates are reasons for a lack of sensitivity

The insensitivity to interest rate changes tends to be most pronounced among firms that do not indicate financial constraints as a top concern and firms with no near-term plans to borrow. Investment is also less interest-rate sensitive at firms expecting higher year-ahead growth. These findings appear to be consistent with survey data on the "hurdle rates" firms report using to make new investments decisions: the average reported hurdle rate has hovered near 15 per cent for decades, despite the downward trend in market interest rates.

The average reported hurdle rate has hovered near 15% for decades, despite the downward trend in market interest rates

Firms' investment plans are quite insensitive to decreases in interest rates, and only somewhat more responsive to interest rate increases. CFOs most frequently cite either ample cash or the low level of interest rates as reasons for this lack of sensitivity. This insensitivity to interest rate changes tends to be most pronounced among firms that do not indicate financial constraints as a top concern and firms with no near-term plans to borrow.

Moreover, firms expecting to grow more tend to have higher hurdle rates, suggesting a possible connection between interest rate insensitivity and high hurdle rates. This may be because these firms have ample cash and are therefore less sensitive to interest rate changes.

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