Speech

Whither Investment? MissouriValleyEconomicsAssociation AdamsMarkHotel St.Louis,Missouri February28,2003 I’m delighted to be here today to speak at ReserveSystem.Ithankmycolleaguesatthe thishometownMissouriValleyEconomics FederalReserveBankofSt.Louis—especially Association conference. It’s always fun for MikeDueker—fortheirassistanceandcomments, metoputonmyacademichatagain.Today butIretainfullresponsibilityforerrors. my chosen topic is investment, which is one of Investmentspendinggrewconsiderablyfaster the most volatile forms of spending. Business thanGDPinthelate1990s.Thecomputerequip- investmenthascertainlyliveduptoitsreputation mentandsoftwarecategoryofbusinessinvest- overthisbusinesscycle.Aswetrytounderstand ment,inparticular,grewatanastoundingrate thelikelycourseoftheeconomyincomingquar- of19percentperyearfrom1995to2000,as ters, the probable behavior of investment, and comparedwithan11percentgrowthratefrom the risks of alternative outcomes, is “topic one.” 1989—thelastfullyearbeforethe1990-91reces- Infact,businessinvestmenthasbeentopic sion—to1995.Aftertheinvestmentboomofthe onecontinuouslyoverthelastcoupleofyears. late1990s,businessfixedinvestmentdeclined Duringandaftereveryrecession,analystsfocus foreightstraightquartersuntilthefourthquarter onthetypeofspending,whetherconsumption, of2002. investment,orgovernment,thatisexpectedto Togetahandleonwhybusinessinvestment drivetheeconomicrecovery.Inmostcases,invest- boomedandwaned,itisusefultorefertoaframe- mentisfrontandcenterbecausethatisthemost workthatplacesimportanceondecidingwhen volatilecomponentofGDP.Typically,economists toinvestaswellaswhethertoinvest.Asalong- watchbothhousinginvestmentandbusiness termproposition,firmswillhavetomakecritical investment,becausetypicallybothhavedeclined investmentsintechnologyinordertoremain substantiallyduringtherecession.Thistime, competitive.Fromabusiness-cycleperspective, housinginvestmentremainedonaremarkably anespeciallyinterestingquestionconcernsthe highplateau,whichmakesbusinessinvestment timingofthatinvestment. centraltoforecastingthepaceofexpansion. Whenanalyzingtiming,itisimportanttorec- Idonotwanttoleavetheimpressionthat ognizethatmostprojectsarenotfullyreversible businessinvestmentistheonlyGDPcomponent oncetheyareundertaken.Nevertheless,because subjecttouncertaintygoingforward.ButIwill mostinvestmentprojectscanbedelayed,currently concentrateonbusinessinvestmentbecausethat availableinvestmentopportunitiesmustbe iswhereIseethegreatestuncertaintiesatthis weighedagainstfutureopportunities.Purchasers time.I’llstartbylookingbackatthewayinvest- ofpersonalcomputers,forinstance,arewellaware mentboomedinthelate1990sbeforeitdeclined oftheneedtoconsiderwhatadditionalcapabili- in2000and2001. tiestheycouldobtaininaPCayearfromnowif Beforeproceeding,Iwanttoemphasizethat thepurchasewerepostponed. theviewsIexpressherearemineanddonot Therate-of-returnhurdlethatarisky,butpost- necessarilyreflectofficialpositionsoftheFederal ponable,projectmustclearinordertojustify 1 ECONOMICGROWTH investmentwithoutdelayriseswiththefollowing timeatthediscretionofthemortgageborrower, threefactors: whereasTreasurybondscannot.Ifthemarket foreseesalowermortgagerateinthefuture,then 1.therisk-freerealrateofreturn; thecurrentTreasurybondyieldwillbecorre- 2.ariskpremiumtocompensateforuncer- spondinglylowrelativetothecurrentyieldon taintyregardingthereturnsontheinvest- mortgage-backedsecurities.Withthissignalof ment;and likelycheaperfinancinginthefuture,theincen- 3.anindicatorofwhetherthecostoffinanc- tiveisforbusinessestodelayinvestment. ingishighnowrelativetowhatitmightbe Whatdothesenumberslookliketoday?The inthefuture.Iffinancingappearsrelatively incentivetodelayhasactuallyincreasedsince expensivetoday,thenprojectsmaybe January2000.Theratiooftheexpectedrealreturn postponed. onGNMAmortgage-backedsecuritiestothe expectedrealreturnon10-yearTreasurybonds Whatdatagiveapproximatefiguresforthese hasrisen.Thisratiowentfrom1.31inJanuary threefactors?And,whatdothesedatatellusabout 2000to1.57inJanuary2003,astheGNMAand marketincentivesandsignalsregardinginvest- Treasuryyieldswentfrom7.97percentand6.66 mentduringtheboomandbust?Therisk-free percent,respectively,inJanuary2000to5.24and realrateofreturniswellproxiedbytheyieldon 4.05percent,respectively,inJanuary2003.The inflation-indexedTreasurybonds.Theyieldon dropinexpectedrealreturnsonbenchmarkcor- the10-yearindexedbondpeakedat4.37percent poratebondssinceJanuary2000,however,has inJanuary2000.Todaythecomparableyieldis morethanoffsetthisincreaseintheincentiveto lessthan2percent.Ifwemeasuremarketrisk delayinvestment,sotherequiredrateofreturn premiumsasthespreadsbetweenyieldsoncor- onnewinvestmenthasdeclinedonnetsince poratebondsofdifferentinvestmentgrades,risk January2000. premiumswereunusuallylowbetween1996and Givenpositiveconditionsbetween1997and thefinancialmarketupsetinthefallof1998that 2000—intheformofbothlowriskpremiumsand followedtheRussiandefaultandLongTerm favorablefinancingterms—itmakessensethat CapitalManagement’snearinsolvency.Chairman businessinvestmentspendingwasinhighgear GreenspantestifiedinFebruary1997that“risk duringmostofthatperiod.Italsomakessense premiumsforadvancingfundstobusinessesin thatasbusinessinvestmentpeakedin2000,the nearlyallfinancialmarketshavedeclinedtonear- demandforfundsandtherealrisk-freeratealso recordlow”(FederalReserveBoardSummary peaked. Report,MonetaryPolicyObjectives:1997 Becausetheboomincomputerandsoftware (February26,1997),p.8).Betweenlate1998and investmentwasparticularlystronginthelate late2000,corporatebondspreadsheldsteadyat 1990s,itisworthconsideringspecialfactors relativelylowlevels.Then,inthefourthquarter behindthistypeofinvestment—aboveandbeyond of2000,corporatebondspreads(AAAtoBBB) themarketconditionsthatfueledinvestmentin increasedbyaboutahalfapercentagepointand general.Iwillnotresortexclusivelytotheclaim haveremainedthere. thattheboomincomputersandsoftwarewasdue Asanindicatoroftheattractivenessofcurrent toexcessivelyoptimisticrevenueprojections. financingterms,wecanusetheyieldonmortgage- Computerinvestmentwasalsostrongbecause backedsecuritiesrelativetotheyieldonTreasury theusualincentivestowaittoinvestweretem- bonds,withbothyieldsadjustedforexpected porarilymutedbyuniquecircumstancesinthe inflation.ThekeydifferencebetweenTreasury late1990s.First,theinitialpublicofferingof bondsandmortgage-backedsecuritiesisthatthe Netscapestockin1995heraldedthewidespread underlyingmortgages,andthereforethemortgage- adoptionoftheInternet.Suddenly,computer backedsecurities,canberepaidatparatany usershadtoworryaboutwhethertheirhardware 2 WhitherInvestment? andsoftwarewerecompatiblewithemerging sideofhigh-tech,industrialcapacityincreased Internetstandardsandauthenticationprotocols— byonly12percent. notjustwhethertheircomputerswouldcontinue Inthisunusualenvironment,itisnotsurpris- torunstand-alonesoftwarefastenough.These ingthatthemarkethadtroubledistinguishing newusesandstandardsclearlyhelpeddestroy howmuchoftheprecedingflurryofinvestment partofthevalueofwaitingtoreplacecomputers andsalesgrowthwaspermanentandhowmuch andsoftware. wastemporary.Theresultwassomemisalloca- TheloomingissueofY2Kcompliancealso tionofcapital,givenwhatweknowtoday,that spurredasurgeincomputerreplacementand yieldedlittlereturnandhurtprofitgrowthfor softwareupgrades.Theusualcalculusofspending theeconomyasawhole.Moreover,becauseof foradditionalfeaturesversusstickingwithcurrent theimportanceofretainedearningsinfinancing equipmentbecameonewherethecurrentset-up investmentspending,theprofitslumphaspro- mightnotrunatallafterJanuary1,2000.Thefact longedtheinvestmentslump.Insomesectors, theprofitslumphasbeenmorelikeaprolonged thattheconsequencesofanyY2Knoncompliance drought.Thecommunicationssectorhasseen11 werehardtoquantifyprobablyonlyhastened straightquartersoflossestothepresent.Theauto- preventiveinvestment.Ofcourse,onceweentered motivesectorhashad10consecutivequartersof theyear2000,theusualincentivestowaitto losses.Theelectronicsandelectricalequipment investinnewcomputersquicklyreturnedto sector,incontrast,turnedthecornerbyending normal.Moore’sLaw—thatprocessorspeeds fivestraightquartersoflossesinmid-2002. doubleevery18months—resumeditsusualrole Afterthisbleakrundown,waitingforthe intemperingtheincentivetobuynow.Theafter- upturnininvestmentmightseemlikewaiting mathofY2Kcausedanespeciallylargeretrench- forGodot.Indeed,theoutlookforcorporateprofit mentincomputerinvestment,however,giventhat growthnowlooksabitlesspromisingthanitdid theaverageageoftheinstalledcomputerbase threemonthsago,althoughdouble-digitprofit wasunusuallylow. growthisstillprojectedfor2003.Forecastershave Inaddition,theso-called“first-moveradvan- correspondinglyreducedtheirprojectionsof tage”wasprobablyoverstatedduringthedot-com growthininvestmentspendingslightly,although era.Theideawasthatonlinesalesinmanylines anuptickinspendingoncomputerequipment ofbusinesswouldturnouttobenaturalnear- andsoftwareisexpectedinthesecondhalfof monopolies.Basedonbeliefinfirst-moveradvan- 2003.Onereasonforcomputerinvestmentto tage,dot-comandtelecommunicationscompanies reboundin2003isthatcomputersdepreciate racedatbreakneckpacetogrowveryquickly,in fasterthanotherformsofcapital.Anyoverhang anticipationofestablishingalargemarketshare. incomputerinvestmentfromY2Kandthedot- Itturnedout,however,thattoomanyentrants comeraoughttobeworkingitswayoutofthe grewfasterthantheirpotentialmarket.Thisphe- systematthistime. nomenonwasmostevidentinthetelecommuni- Muchofthereneweddemandforcomputer cationssector,wherefiberoptictrafficeventoday andsoftwareinvestmentisexpectedtocome isfarbelowtheinstalledcapacity.Tomakematters fromfinanceandservicefirms.Thisexpectation worse,telecommunicationsfirmsunderestimated isconsistentwiththeviewthattheU.S.manufac- technicalprogressinsendinglargeamountsof turingsectorisexperiencingnotonlytheeffects dataovereachphysicalfiber.Theyalsooveresti- ofarecessionbutalsoacontinuationoftheshift matedthewillingnessofcustomerstopayto towardaserviceeconomy.Totheextentthat connecttheirdesktopstothefiber—thelast-mile someofthedeclineinmanufacturingissecular, problem.Itisstrikingtonotethatindustrialcapac- investmentbymanufacturerswillnotnecessarily ityinhigh-techgoodsmorethanquintupled bouncebacktopreviouslevels.Furtherevidence between1995and2000.Formanufacturingout- oftheweaknessinmanufacturingisthehigh 3 ECONOMICGROWTH vacancyrateforindustrialplants,whichisat Thebottomlineseemstobethatfundamentals recorddouble-digitlevels.Housinginvestment supportingincreasinginvestmentareinplace. isnotexpectedtohaveasharpreboundeither, However,geopoliticaluncertaintiesleaveus largelybecauseitdidnotweakenappreciably withevidence,fromtherelationshipofTreasury duringthe2001recession.Housingwasbuoyed yieldstomortgage-backedsecuritiesyields,that byattractivemortgageratesandthefactthat,since firmscurrentlydohavesomeincentivetodelay 2000,itofferedoneofthefewsourcesofcapital investmentrelativetoconditionsseveralyears gains. ago.Theseincentivescouldchangequickly; Rightnoweveryonehearsnumerousrefer- lesseningofgeopoliticalconcernswouldchange encestogeopoliticalriskanditseffectonthe expectationsandchangetheincentivetodelay economy.Onepositiveelement,however,isthat investment. investmentspendingwillreceiveaboostfrom Anaturalquestioniswhethermonetarypolicy acceleratedfirst-yeardepreciationallowances canencourageinvestmentspendinginthecur- fornewplantsandequipment.TheJobCreation rentenvironment.Intermsofriskpremiumsand andWorkerAssistanceActof2002allowsfirms incentivestopostponeinvestmentintheframe- toclaimafirst-yeardepreciationallowanceof44 workIlaidoutearlier,monetarypolicycan percentinsteadoftheusual20percent.This contributepositivelybyavoidinginflationsur- depreciationbonusisavailablefornewinvest- prises—bothinflationaryanddeflationary— mentbetweenSeptember2001andSeptember whichwillhelpensurethatmarketriskpremiums 2004.FirmshaveknownaboutitsinceMarch arenotelevatedbyanunnecessaryinflationrisk 2002,butitsfulleffectmightnotbefeltuntilthis premium.IftheFeddoesitspart,firmsandindi- year—orevenearlynextyear—whenthebonus vidualswillreceiveclearersignalsoftheexpected caninteractwithamorevibranteconomy. rateofreturnrequiredofeachtypeofprospective Anotherpositiveinthepictureisthatover investmentproject,whichwillhelpthemarket comingquartersfirmslikelywillbegintoacton weedoutthebadfromthegood.TheFed,obvi- declinesinthecostofcapital.Combiningtherisk- ously,hasnodirectroleinresolvingthegeopoliti- freerate,ariskpremiumandtheincentivetowait caluncertaintiesbutdoeshavearole,whichI toinvest,thecostofcapitalisnowbackdownto thinkitisfulfilling,inmaintainingasoundlong- thelevelslastseeninearly1998andearly1999— runfinancialenvironment.Iamverybullishon atleastwhenusinganinvestment-gradecorporate thelong-termcapacityoftheAmericaneconomy bondyieldtomeasurethebenchmarkreturn.If togenerateplentyofgoodinvestmentopportuni- insteadweusetheexpectedreturnonequities tiesthroughinnovationandproductivitygrowth. asabenchmarkreturn,thecostofcapitaltoday isconsiderablylowertodaythaninthelate1990s. 4

William Poole (2003, February 27). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_20030228_poole

@misc{wtfs_speech_20030228_poole,
  author = {William Poole},
  title = {Speech},
  year = {2003},
  month = {Feb},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_20030228_poole},
  note = {Retrieved via When the Fed Speaks corpus}
}