Business debt is a transmission mechanism of monetary policy, but its effectiveness can be blunted by inflation. In theory, Fed rate hikes can dampen economic activity by raising business interest expenses and reducing the availability of financing. But inflation works against this channel by increasing business revenues and the value of business assets, which can be used as collateral to raise financing. The Fed’s hikes appear significant, but are muted when contrasted with the surge in corporate profits and asset values. This post looks at the impact of recent rates hikes on the income and balance sheets of non-financial corporations and suggests that they are not obviously constraining.
The nonfinancial corporate sector does not appear to be highly dependent on debt financing, as debt is a relatively small share of the sector’s overall balance sheet. Nonfinancial corporate debt has been steadily increasing, but it is overshadowed by a greater surge in asset values. This sector level view glosses over the potential vulnerabilities in certain firms or industries, but also suggests aggregate financial strength and places limits on potential systemic distress. A little less than half of the sector’s assets are financial, with notable holdings in direct investment abroad, trade receivables and cash equivalents. But most assets are tangible nonfinancial assets that could be pledged as collateral for a bank loan.
The value of tangible assets held by nonfinancial corporate businesses has surged over the past few years in line with high inflation. Recall, the overall price level as measured by CPI has risen by around 20% since 2019. Inflation has increased the market values of the real estate holdings of non-financial corporates by $3 trillion since 2019, and even increased the market values of their inventory and equipment by around $2 trillion. This rise in asset values mitigates against tightening bank credit standards, as businesses appear in better financial condition and are able to pledge more collateral for a given loan amount.
The post-pandemic inflationary boom led to a spectacular surge in corporate profits that suggest ample capacity to afford higher interest expenses. By definition, inflation raises the price level of goods and services and thus mechanically increases revenues. Business costs rise as well, but even a bit of operating leverage would indicate greater growth in profits. Profits have come down from recent highs, but at $2t are still historically high and a cushion against higher rates. More broadly speaking, interest expense is not a major cost for nonfinancial corporates to begin with. For context, interest expense for nonfinancial corporates is a few hundred billion annually while employee compensation is around $8t.
Rate hikes also increase the interest income of nonfinancial corporate businesses and have actually decreased their net interest payments in 2023Q1. This is likely due to the sector’s $3t holdings of deposits and money fund shares, whose interest rates have quickly reset higher with each Fed hike. In contrast, the sector’s liabilities were originated at historically low interest rates with maturities staggered over the coming years. The inverted yield curve suggests that the full impact of higher borrowing rates will continue to be blunted by rising interest income. Note that medium term rates and IG spreads are below their peak last year, indicating that borrowing costs have actually declined despite the Fed’s signal of more hikes.
While higher rates may slow business activity, it is also worth remembering that financing costs are only one factor among many that impact business activity. A decade of historically low interest rates post-GFC did not appear to stimulate nonfinancial businesses activity, so the reverse could also be true. Hiring and investment decisions depend on a wide range of factors beyond the cost of financing, notably anticipated demand. There is also research that suggests that our economy today is less rate sensitive, as businesses tend to be services oriented and thus less capital intensive. Even if a business needs cash, it could adapt to higher rates by adjusting its financing structure to rely more on internally generated funds, reducing dividend payments, or reducing shareholder buybacks.
Monetary policy so far has not been as effective as expected, so that implies more will have to be done. Obvious channels of policy transmission like housing and financial assets are seemingly resilient, and the business interest channel may also be surprising. But with enough hikes, eventually interest expenses will be meaningfully large and business asset values will decline.
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