By Greg Ip 

One of the great mysteries of the recovery is why low interest rates have done so little to lift business investment.

After all, that is supposed to be one of the ways monetary policy works: A lower cost of capital makes any project more viable. But what if lower interest rates are actually hurting investment by encouraging companies to pay dividends or buy back stock instead?

That's the theory advanced by economist Jason Thomas of private-equity giant Carlyle Group. It is at odds with conventional economics but has some intuitively appealing logic and supportive data.

He calculates that since 2009, just after the Federal Reserve took interest rates to near zero, U.S. companies have boosted stock buybacks by 194% and dividends by 66.5%, but investment by 44%. Big energy companies have been slashing capital expenditures while boosting payouts. Even companies without the headwind of lower commodity prices are holding the line: McDonald's Corp. and Eli Lilly & Co. are maintaining flat capital expenditures while raising dividends; Verizon Communications Inc. said it plans to trim its capital budget and has raised its dividend.

Many critics have accused Fed policy of hurting the economy, but they make a fuzzier argument that exotic monetary policy such as zero interest rates and bond buying foments uncertainty and thus undermines investment.

Mr. Thomas's argument relies instead on basic corporate finance. Companies can choose to distribute cash to shareholders as dividends or share repurchases or invest it in the business. In theory, an investment that raises future cash flow also raises future dividends and should be just as appealing as a higher dividend today, irrespective of interest rates. But Mr. Thomas says this assumes investors don't care whether they get their dividends today or tomorrow. In fact, he says, investors such as retirees have a strong need for current yield and will pay a premium, in terms of the price to earnings ratio, for a company that distributes more of its income today.

Since 1976, higher-yielding stocks systematically outperform the overall market by 0.76 percentage point when inflation-adjusted interest rates fall 1 percentage point, Mr. Thomas finds. Moreover, the relationship becomes more extreme the lower rates go and the longer they stay low.

"John Bull can stand many things but he cannot stand two per cent," Walter Bagehot, a 19th century editor of the Economist, once said, describing investors' need for some minimum level of income.

When real five-year bond yields dropped 0.5 percentage point between this February and May, the Standard & Poor's Dividend Aristocrats Index -- made up of companies that increased their payout every year for at least 25 years -- outperformed the S&P 500 by 4.8%. This means that the lower rates go, the higher a hurdle a new investment must meet to boost the stock price more than a higher dividend.

Not all companies would respond the same way. Young companies with no internal cash flow and tech companies that are valued more for their growth have little option or incentive not to invest in their businesses. They would be less affected than large, mature companies with higher depreciation expenses and cash flow.

Mr. Thomas may have solved part of the puzzle of low investment, but not the entire puzzle. He has found that low interest rates boost the performance of stocks that pay high dividends but hasn't shown that dynamic influences companies' investment decisions. While dividend considerations might give companies one reason not to invest more when interest rates are low, it isn't clear how important that effect is in the scheme of things. A company may see few promising capital projects and thus conclude it would rather return the cash to shareholders. This wouldn't be because interest rates are low. It would be reflecting the same forces that are keeping rates low -- too much cash chasing too few profitable investments.

Countless other factors affect the decision to invest, the most important being the outlook for sales, which tends to benefit from low interest rates which boost consumer spending. Higher interest rates would damp consumer spending and push up the dollar, both of which would hurt sales and thus investment. Moreover, for companies that don't have publicly traded shares or pay high dividends, the traditional benefit of low rates on investment is probably still more important than the effect on the share price.

Nonetheless, when interest rates have been so low for so long, it is worth re-examining old relationships.

Write to Greg Ip at greg.ip@wsj.com

(END) Dow Jones Newswires

June 05, 2016 05:44 ET (09:44 GMT)