We have looked very closely at investment spending and tried to understand why it has been so very depressed in the aftermath of the crisis.

You know, I think one reason for it is simply that the economy's been growing slowly. Sales growth has been slow and many firms have found they actually don't need to invest very much in order to satisfy the demand growth that they're seeing.

The workforce has been expanding less quickly than it had been. When you have a rapidly expanding workforce firms need, they're hiring those people and they need to invest to equip new entrance with the tools to be productive that others already in the workforce has. Slowing in the workforce has also played a role, but beyond that, I mean, would agree with you that there's been...

... [T]he health of the U.S. economy depends importantly on the vitality of the small business sector, and continued access to credit on competitive terms is necessary for that vitality. On balance, since last fall credit supply conditions have almost surely tightened for the vast majority of small businesses. Credit appears to be generally available, but at a higher cost. Only a small fraction of small business owners report that credit is their main business concern. Demand for their products is much more problematic.

Looking forward, continuing declines in the value of small businesses' real estate assets have the potential to substantially affect the ability of those small businesses to borrow. Similarly, declines in the value of real estate may affect the ability and willingness of banks and other lenders to supply loans. Indeed, this is likely already occurring to some extent at some banks across the full spectrum of bank sizes. Lastly, because of interdependencies between small business and household finance, declines in the financial condition of households can also affect both the terms of those households' small businesses loans and their ability to borrow.  

Commercial real estate is another area that requires close supervisory attention.  The delinquency rate on commercial mortgages held by banking organizations almost doubled over the course of 2007 to over two percent.  The loan performance problems were the most striking for construction and land development loans--especially for those that finance residential development--but some increase in delinquency rates was also apparent for loans backed by nonfarm, nonresidential properties and multifamily properties.

[W]e would expect that the direct effect of current events on small businesses would be limited.  Indeed, the data we have on business lending at small banks show that such loans have continued to expand at a fairly robust pace through mid-October.  Such data and our conversations with bankers suggest that, at least to date, the supply of credit to small businesses remains healthy.  

Business investment faltered late last year, with weaker sales of autos and construction materials apparently playing important roles. Most of the fundamentals for business investment are still quite positive, however; profitability is high and the cost of capital is still fairly low, despite recent financial market developments. Thus investment could well maintain momentum this year, I believe, and we have been seeing some favorable signs.

High levels of energy prices spurred ongoing strong growth in mining and drilling activities. But the recent declines in energy prices make it less likely that we will see further large increases in such expenditures going forward. So some slower growth in structures investment may be expected in 2007.

In fact, at least until quite recently when measures of business spending weakened, non-residential construction served to offset a portion of the impact of the housing investment slowdown.

The outlook for real growth in 2007, then, is for continued strength in consumer spending and business investment to be partially offset, particularly early next year, by the drag from the housing market.  Growth will start the year on the low side, but should be back to about 3 percent by the end of next year.  So my best guess right now is that real GDP growth will average between 2 ½ and 2 ¾ percent in 2007. 

The fundamental underpinnings of near term investment demand are encouraging. Profitability is high, capacity utilization has been steadily rising, and many firms see strong demand for their products. Thus, it is not surprising that new orders for capital equipment increased 7.5 percent over the last year, and I see a solid outlook for capital spending over the next several quarters.

With a few exceptions, business inventories appear to be well aligned with sales, which reduces the risk that a buildup of unwanted inventories might act to reduce production in the future.

One of the most striking financial developments since 2001 has been the rapid increase in corporate holdings of cash and short-term securities.  Since the end of 2001, the ratio of cash holdings to assets has risen sharply (see exhibit).  This increase is even more pronounced when (on a consolidated basis) cash is measured relative to investment, defined as the sum of capital spending and research and development (R&D) spending during the preceding twelve months.  The ratio of cash to investment has averaged about 60 percent during the past few decades.  Generally, it is higher in recession periods, consistent with a strong precautionary savings motive by firms that face costly external financing (Almeida, Campello, and Weisbach, 2004).  And, in 2001, the ratio of cash to investment was already somewhat elevated.  But the ratio then soared to more than 150 percent by year-end 2004, as investment fell far short of cash flow from operations and net financing.  This juxtaposition is unusual when the economy is expanding. 

Leading indicators of commercial construction spending, such as billings by architectural firms for design work, point to further increases in activity in coming months. An upturn in commercial construction could offset part of what is anticipated to be a waning contribution to GDP growth from the housing sector.

On the business side, I look for capital spending to continue to expand at a decent pace again this year. Stronger economic growth abroad will also boost American exports. These two sectors - business spending and exports - are likely to mitigate the effects of a slowdown in the consumer and housing sectors.

The outlook for business investment should remain quite favorable even as the pace of overall activity moderates. Against a backdrop of sustained growth in sales, businesses should be well positioned to undertake potentially profitable projects.

The Federal Reserve’s most recent survey of bank lending practices, which was conducted in April, indicates that domestic banks are noticing increases in requests for business loans. They also indicated an increased willingness to supply business loans in an environment of brisk competition from other lenders, a liquid secondary market for business loans, and an increased tolerance for risk.