Inflation-adjusted interest rates, investment and the middle market

A confluence of events and policy shifts has coalesced into a unique opportunity for middle market firms to make long-term strategic investments in their firms. Interest rates, once adjusted for inflation, reside in negative terrain. This implies that firms should take advantage of those historically low borrowing costs to increase productivity-enhancing investment to prepare for the intense competition that will characterize the post-pandemic economy.

In that economy, it will be necessary for firms to pull forward investments in software, equipment and intellectual property that would have occurred over the decade into the next 12 to 24 months to prepare for the reopening of the $21.7 trillion U.S. economy and the global supply chains that support it. The potential return on investment amid real negative interest rates demands that midmarket firms act boldly and decisively to integrate advanced technologies into the production of goods and provision of services to prepare for what will be a very different economic and financial landscape than before the pandemic.

“U.S. middle market firms should act decisively to take advantage of real negative interest rates to bolster market position and create the conditions to thrive in the coming expansion.” — Brian Becker, RSM National Consulting Leader

Moreover, given the shape of the yield curve and real negative interest rates well beyond the 10-year interval, an increase in spending, especially on productivity-enhancing projects, makes economic sense and will bolster the long-term prospects of the middle market firms that have the foresight to act now. Proprietary survey data taken from special questions inside the RSM US Middle Market Business Index survey over the years has consistently pointed to a deficiency in outlays on capital expenditures across the middle market.

Over the past decade, a low central bank policy rate worked in concert with reduced expectations for growth and inflation, all of which acted to pressure the entire yield curve lower. With yields out to a 10-year maturity at roughly 1% and with the inflation rate running at 1.4%, inflation-adjusted yields out to 10-year maturity turned negative.

The agenda of the incoming Biden administration includes aggressive short-term spending and long-term infrastructure projects as part of its response to pandemic economic losses. The damage wrought by the pandemic and the coming fiscal largesse almost assure that monetary policy will continue to be directed at damping the long end of the yield curve in the coming year. Over the next year, the Federal Reserve will continue to purchase $120 billion ($80 billion per month in U.S. Treasurys and $40 billion in mortgage-backed securities) in assets per month, which implies that the cost of borrowing at the long end of the yield curve will remain low in nominal terms and remain negative in inflation-adjusted (or real) terms.

That is, 30 years from now, pandemic debt will be retired in deflated dollars. Though nominal interest payments will require $650,000 for each million dollars of issuance, those payments will have been deflated such that the cost of the bond will be negative $90,000 in 2020 dollars.

Though this would sound ridiculous in normal times, these times are anything but. Due to the unique confluence of events that is upon us, firms will actually make money by borrowing, because we are operating at near-zero nominal interest rates that become negative when adjusted for inflation.

With the Federal Reserve anchoring the front end of the yield curve with a zero policy rate (the Fed intends to keep it there until 2023) and the U.S. economy still operating well below potential, the next few years will be defined by inflation-adjusted interest rates that are negative. This provides a tremendous opportunity for middle market firms to make transformational investments to complement the era of technology, telework and automation that is upon us.

Fortune favors the bold. Now is the time to act. Those middle market firms that choose to invest in their firms and personnel will create the conditions to thrive in the coming economic expansion.