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Stifling Investment and Productivity: Ironically, the Fed’s Rate Hikes Promote Long Term Inflation [1]
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Date: 2023-11-10
James D. Shelton
James Shelton is a Retired Epidemiologist and Stock Market Investor
Phenomenal Productivity Gains are All Around Us . The price of sequencing the DNA in a genome, instrumental in advancing medicine and agriculture, decreased from an estimated $1 million in 2007, to $600 in 2014, to less than $100 in 2023 - with innovation from start-up companies taking the lead. This major decline prospered when consistent low interest rates fostered investment.
Such opportunities abound in our economy for high-reward productivity-enhancing investment. The most prominent is artificial intelligence. But there are numerous others in communications technology, green technology, agriculture, biotechnology, robotics and other manufacturing technology, retail & other services technology and many others. Such technological advancement that increases productivity notably leads to disinflation and thus is a huge antidote and offset to inflation, as well as improving quality of life.
Here’s the pathway: Investment→ Innovation→ Productivity→ Reduced Prices & Growth
The Flow of Investment Funds . Investment capital largely comes from banks, stock market and bond investors, and venture capital, provided to businesses which in turn invest in innovation. But in allocating money, investors must consider the potential return on investment, in light of uncertainty of return, competition with alternatives such as distribution of profits, compensation to employees, and setting aside cash for contingencies.
Fed’s High and Rapid Rate Hikes Markedly Discourage Investment - in an important number of ways. First, most obviously, increasing interest rates directly increases the cost of borrowing for investment, and thus directly discourages it. This significant increase in “cost of capital” is a major direct drag on investment.
Second, expectation of a major slowdown in the economy, discourages investment, as businesses fear they will be caught up in the downturn and their investments become a losing proposition.
Third, rate hikes, and particularly rapid rate hikes foster uncertainty. When businesses have little clarity about the future, they become loath to take the risk of investing. At the same time, upstream sources of business capital like banks, also tighten their lending standards in anticipation of higher lending risk.
Fourth, high yields on Treasury Bonds and the like, are direct competition and drain away capital for investment in stock market-listed business, as well as venture capital’s investment in start-up companies - that is hugely important for much productive innovation.
Lastly, rate hikes, especially rapid ones cause disruptions that discourage investment. We saw this with the regional banking crisis this past spring. The rapid rise in long term interest rates, especially left smaller banks flat-footed, holding US Government and similar long term assets, that rapidly declined in value. Thus, many smaller banks, the primary lender for many communities and small businesses, had to increase reserves and cut back lending. Likewise major disruptions are currently occurring in the housing industry, as steeply rising mortgage rates have caused a major downturn in the new housing market.
Evidence of Major Drag on Investment. Sure enough, the Fed’s own quarterly survey of senior loan bank loan officers - a good barometer of investment overall - provides ample evidence for both ongoing significant bank tightening and reduced demand from businesses which borrow. Its latest two quarterly bank lending surveys, found significant ongoing tightening, specifically for commercial and industrial lending. The latest released for October 2023 found continuing tightened bank standards, with banks citing “a less favorable or more uncertain economic outlook” and “a reduced tolerance for risk”. Probably even more importantly, banks reported “weaker demand for loans from firms of all sizes.”
Moreover, Goldman Sachs’s recent poll of 10,000 small business owners found that only 29% said they can afford to take out a loan, given current interest rates.
Caveats . Of course our economy is hugely complex with many moving parts. Increased productivity does not always directly lead to lower prices. Businesses with improved productivity may wield pricing power to hold prices steady. But competition will often induce such businesses toward lowering their prices. And disinflation is not spread evenly across the economy, so the offset to inflation is uneven.
New Normal of Innovation/Productivity Vigor. The resilience of our economy has been surprising if not amazing, despite the Fed’s aggressive demand-destroying approach, grounded in the mindset of the 1970’s and 80’s. Much of that resilience is surely stimulated by government spending. But in the current era, we have hatched a powerful virtuous cycle engine, where rapid innovation breeds yet more and more innovation. It steams along regardless of other forces. Surprisingly few seem to be aware of the current key role of technology-driven productivity in our economy.
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