Neel Kashkari of the Federal Reserve Bank of Minneapolis sat at the front of a meeting room at Cargill recently and wondered aloud if he could have heard right.
Was Cargill’s chief financial officer really suggesting that higher interest rates — and thus higher costs to borrow money — is what it would take to get corporate executives to invest more capital in their businesses?
Cargill CFO Marcel Smits laughed and took another shot at explaining what he meant.
Smits and others have observed that since the Great Recession the world’s central banks, including the U.S. Federal Reserve, continued to do what they could to keep interest rates down and stimulate their economies. The folks in charge of companies like Cargill can’t help but conclude from this that the economy must still be really sick.
“If you would gradually start increasing rates, I think people would say, ‘We’re back into a more normal world,’ ” Smits said. “That would drive confidence in boardrooms and would allow people to say, “You know what, this feels a little more normal.’ ”
This is not a silly observation, of course. Business leaders can’t know for sure what would happen to the global economy if central banks like the Fed retreated completely from their policies of stimulating the economy.
Yet maybe it’s time to be reminded of one common misconception in business, a sort of certainty executives develop that markets and economies are cyclical and in the fullness of time things will get back to normal. Sometimes things just don’t — and capital spending could be among them.
What if the 10-year Treasury note interest rate, lately creeping up to about 2.6, percent, is still more or less the same in a few years? Will corporate boardrooms still be full of people who lack the conviction to approve a bigger capital investment budget?
What the Fed does
Kashkari, the president of the Minneapolis Fed, was entering the blackout period around Fed monetary policy meetings last week and wasn’t available for a conversation.
But his appearance with Smits at Cargill’s Minnetonka headquarters covered a lot of fertile ground.
Among other things Kashkari talked about was what the Fed really does. In part he stressed what the Fed can’t do, and that’s control long-term interest rates. The rates react to what’s happening in the global economy.
What Kashkari called the “neutral” rate of interest — a rate that doesn’t juice the economy or slow it down — has generally been drifting lower, too. It was far higher in the dot-com era of nearly 20 years ago, according to one Fed analysis, although the gentle decline since then turned into a precipitous slide during the Great Recession.
So longer-term interest rates are simply a lot lower. But with money available at low cost in the market, a curious thing happened inside big companies as they analyzed whether to borrow some of that far cheaper money and invest it: They didn’t reduce the rate of return they expected to get when looking for good projects.
This is called the hurdle rate, and it’s so fundamental to business that if the CEO or business owner doesn’t get it, then it’s just a matter of time before he or she makes a serious blunder.
A hurdle rate or target rate is nothing more than the minimum return on an investment that would justify funding a purchase, maybe of something like a new piece of equipment.
Smits told Kashkari that there’s a heated debate underway at Cargill now about what the right number should be. For a big company like Cargill, the target rate might be 9 percent; it could be much higher for smaller companies.
We can skip an explanation of how to figure out the right rate, but obviously one thing that matters is the cost of the money needed for the project. After all, the project has to generate returns at least equal to what it cost for all the capital that went into it, the loan interest and the cost to use the stockholders’ capital.
How risk figures in
But if the cost of the money needed for a project is perhaps a couple of percentage points less than it was a dozen years ago, shouldn’t the hurdle rate decline by the same amount? With money cheaper than it has been in generations, why would managers keep the financial hurdle artificially high, so high that some good projects can’t cross it?
Smits suggested one explanation for why corporate executives haven’t rethought their expectations even as capital stayed cheap. Any investment analysis must account for risk, and a shaky broader economy or problems in the financial sector that didn’t get fixed mean that just about any project is riskier than it would’ve been in more stable times.
But there’s an explanation for tepid business investment that seems even simpler: Business executives don’t want to invest. Businesses have to adapt to the market, and asset-light models that use as little financial capital as possible are now common. And that’s not cyclical.
A decline in business spending has been going on for a while, and one marker is in capital goods spending. Orders for goods like these nearly dried up in the Great Recession. Business spending has since recovered, but if you take into consideration how much the economy has grown in the last 20 years, orders were almost twice as high during the economic boom years of the late 1990s.
Changes in how companies invest could explain why Kashkari wasn’t buying an argument for the recent corporate tax cut: that American companies would invest the money they will finally be bringing back home from foreign operations now that the U.S. tax rate got cut.
“These big companies that have had these cash balances abroad can already borrow at much lower [rates] than their hurdle rate,” Kashkari said at the Cargill meeting. “So if there were good investments to be made, they’d already be making those investments.”