If the impact of increased uncertainty on investment is the only reason for the Bank of England to change interest rates post BREXIT, then it is important to recognise that a cut in interest rates could increase, not reduce, the relative value of waiting. Most investment decisions come with the option of waiting, and the relative value of this option increases not just when uncertainty rises, but also as interest rates fall. In other words, it becomes optimal to wait longer, as the value of waiting for more information goes up when either the future is less heavily discounted or uncertainty rises. Furthermore, the impact of the value of waiting is magnified at low interest rates. While any decision on monetary policy involves weighing up the (potentially competing) implications of a wide range of factors, this aspect of the option value of waiting has received little attention, and it will be important to add it to the mix.
The vote to leave the EU on June 23 has significantly increased regulatory uncertainty in the UK. No one knows how the UK’s domestic regulatory environment will evolve once it is “freed from the shackles” of EU regulation. Similarly, no one knows what deal the UK will negotiate with the EU, creating uncertainty about the access firms based in the UK will have to the EU market. Although it is clear is that all the possible trade deals with the EU will increase trade barriers in some form or another (for more on why see here), no one knows what form the new barriers to trade will take. Furthermore, only time will tell if trade deals with countries outside the EU will be able to deliver better access than the UK would have been able to secure from within the EU. Indeed, even the terms of the UK's WTO membership will need to be renegotiated, as it is currently based on the UK’s adoption of EU rules, creating further uncertainty.
For obvious reasons this increased uncertainty increases the option value of waiting. If firms delay before making investment or hiring decisions, they may have better information about what the changes will be and therefore whether the decision will be profitable. As more information will help them make better decisions, they will put off making them for as long as possible, particularly where they involve sunk costs.
As more firms are likely to decide to wait and see before investing, this implies the economy is likely to slow. Therefore, in the wake of this increased uncertainty there have been calls by some for the Bank of England to cut interest rates immediately, as well as to increase the level of Quantitative Easing (QE) that they are undertaking.
To understand what impact this will have it will be important to consider the value to firms of waiting – the impact of discounting on investment hurdle rates for a given level of uncertainty means that the option value of waiting goes up, not down, when interest rates fall. Furthermore, at lower levels of interest rates this impact is magnified. In other words, as interest rates fall it becomes optimal to wait longer, as when the future is less heavily discounted the value of waiting for more information goes up. This will affect the trade-offs associated with cutting rates.
The reasons underpinning this mechanism are set out in a paper by Avinash Dixit in the Journal of Economic Perspectives and the calculations underpinning Chart 1 are based on the simple example he uses to illustrate how the option value of waiting works and why it is important. The chart compares the returns needed to trigger investment under the option value of waiting to the case where this option is not considered. It shows that the implications of the value of waiting become more important as interest rates fall, as the ratio of the returns that would trigger investment under the two cases rises and that these increases are particularly large at low interest rates, or increased uncertainty.
The good news is that the option value of waiting applies not just to investing, but also to disinvesting. The band of inactivity created by the benefits of waiting for more information can cut both ways. Therefore, under increased uncertainty and low interest rates, firms may wait longer before either scrapping investment or reducing headcount.
The real world is obviously more complicated than the example set out in Dixit’s paper, and the predictions of his model can be difficult to test. However, there is evidence to suggest that the mechanisms he identified play a role in practice. For example, where investment decisions are irreversible, periods of increased uncertainty are linked to delays in investment decisions. Similarly, hurdle rates measured from surveys of firms have shown no signs of falling since the start of the century, despite significant falls in bond yields, and firms’ stated investment intentions are much less sensitive to cuts in interest rates than increases. (For a summary of this evidence see the discussion in Section 5.b of the Independent Economists Group’s report on Investment, Growth and Capital Markets Union, which can be found here.)
This means that the Bank of England will need to consider the option value of waiting in its assessment of the implications of BREXIT for monetary policy. The impact of increased uncertainty on investment is obviously not the only factor that the Bank of England will need to consider. For example, any reduction in demand or employment may make it harder for firms or individuals to make interest payments on the debt that they hold, so cutting interest rates would help them. However, cutting rates would make things worse for other groups, such as savers and companies with defined benefit pension schemes (as pension liabilities go up as interest rates fall). It will therefore be important to include the impact of the option value of waiting on investment decisions when evaluating these trade-offs, as for a given cut in interest rates the value of waiting increases more if the level of interest rates is lower to start with.
[Updated version of blog post published on 28/7/16]
The vote to leave the EU on June 23 has significantly increased regulatory uncertainty in the UK. No one knows how the UK’s domestic regulatory environment will evolve once it is “freed from the shackles” of EU regulation. Similarly, no one knows what deal the UK will negotiate with the EU, creating uncertainty about the access firms based in the UK will have to the EU market. Although it is clear is that all the possible trade deals with the EU will increase trade barriers in some form or another (for more on why see here), no one knows what form the new barriers to trade will take. Furthermore, only time will tell if trade deals with countries outside the EU will be able to deliver better access than the UK would have been able to secure from within the EU. Indeed, even the terms of the UK's WTO membership will need to be renegotiated, as it is currently based on the UK’s adoption of EU rules, creating further uncertainty.
For obvious reasons this increased uncertainty increases the option value of waiting. If firms delay before making investment or hiring decisions, they may have better information about what the changes will be and therefore whether the decision will be profitable. As more information will help them make better decisions, they will put off making them for as long as possible, particularly where they involve sunk costs.
As more firms are likely to decide to wait and see before investing, this implies the economy is likely to slow. Therefore, in the wake of this increased uncertainty there have been calls by some for the Bank of England to cut interest rates immediately, as well as to increase the level of Quantitative Easing (QE) that they are undertaking.
To understand what impact this will have it will be important to consider the value to firms of waiting – the impact of discounting on investment hurdle rates for a given level of uncertainty means that the option value of waiting goes up, not down, when interest rates fall. Furthermore, at lower levels of interest rates this impact is magnified. In other words, as interest rates fall it becomes optimal to wait longer, as when the future is less heavily discounted the value of waiting for more information goes up. This will affect the trade-offs associated with cutting rates.
The reasons underpinning this mechanism are set out in a paper by Avinash Dixit in the Journal of Economic Perspectives and the calculations underpinning Chart 1 are based on the simple example he uses to illustrate how the option value of waiting works and why it is important. The chart compares the returns needed to trigger investment under the option value of waiting to the case where this option is not considered. It shows that the implications of the value of waiting become more important as interest rates fall, as the ratio of the returns that would trigger investment under the two cases rises and that these increases are particularly large at low interest rates, or increased uncertainty.
The good news is that the option value of waiting applies not just to investing, but also to disinvesting. The band of inactivity created by the benefits of waiting for more information can cut both ways. Therefore, under increased uncertainty and low interest rates, firms may wait longer before either scrapping investment or reducing headcount.
The real world is obviously more complicated than the example set out in Dixit’s paper, and the predictions of his model can be difficult to test. However, there is evidence to suggest that the mechanisms he identified play a role in practice. For example, where investment decisions are irreversible, periods of increased uncertainty are linked to delays in investment decisions. Similarly, hurdle rates measured from surveys of firms have shown no signs of falling since the start of the century, despite significant falls in bond yields, and firms’ stated investment intentions are much less sensitive to cuts in interest rates than increases. (For a summary of this evidence see the discussion in Section 5.b of the Independent Economists Group’s report on Investment, Growth and Capital Markets Union, which can be found here.)
This means that the Bank of England will need to consider the option value of waiting in its assessment of the implications of BREXIT for monetary policy. The impact of increased uncertainty on investment is obviously not the only factor that the Bank of England will need to consider. For example, any reduction in demand or employment may make it harder for firms or individuals to make interest payments on the debt that they hold, so cutting interest rates would help them. However, cutting rates would make things worse for other groups, such as savers and companies with defined benefit pension schemes (as pension liabilities go up as interest rates fall). It will therefore be important to include the impact of the option value of waiting on investment decisions when evaluating these trade-offs, as for a given cut in interest rates the value of waiting increases more if the level of interest rates is lower to start with.
[Updated version of blog post published on 28/7/16]
RSS Feed