The RBA released the September 2016 edition of the Bulletin today. The article “The Household Cash Flow Channel of Monetary Policy by Helen Hughson, Gianni La Cava, Paul Ryan and Penelope Smith is interesting, but possibly flawed.
It looks at the impact of households when the cash policy rate is changed. Lower interest rates can encourage households to save less and bring forward consumption from the future to the present (the inter-temporal substitution channel).
Lower interest rates can also lift asset prices, such as housing prices, and the resulting increase in household wealth may encourage households to spend more (the wealth channel). Additionally, lower interest rates reduce the required repayments of borrowing households with variable-rate debt, resulting in higher cash flows and potentially more spending, particularly for households that are constrained by the amount of cash they have available. At the same time, lower interest rates can reduce the interest earnings of lending households, which may, in turn, lead to lower cash flows and less spending for these households. These last two channels together are typically referred to as ‘the household cash flow channel’.
The analysis in this article focuses on a fairly narrow definition of the cash flow channel. It examines the direct effects of interest rates on interest income and expenses, but abstracts from monetary policy changes that have an indirect cash flow effect by influencing other sources of income, such as labour or business income.
Household disposable income, or cash flow, comprises wages and salaries, property income (including interest paid on deposits) and transfers, less taxes and interest payments on debt. The household sector in Australia holds more interest bearing debt than interest earning assets. Indeed, households have increased their debt holdings at a rapid pace since the early 1990s, mainly due to an increase in mortgage debt. For the household sector as a whole, the level of household debt now exceeds the level of directly held interest earning deposits by a significant margin. However, since the mid 2000s, slower growth in household debt and increases in interest-earning deposit balances (including balances held in mortgage offset accounts) has led to a decline in net interest bearing debt. This means that the household sector is a net payer of interest. Household net interest payments increased through the 1990s and early 2000s, mainly reflecting the rise in net household debt, but trended down from 2007 as interest rates and net debt declined.
The data shown above do not account for interest earning assets held in managed superannuation accounts, which have increased substantially since the early 1990s. The majority of these assets cannot be accessed until retirement.
This article finds evidence for both the borrower and lender cash flow channels, but the borrower channel is estimated to be the stronger channel of monetary transmission. One reason for this is that while there are roughly similar shares of borrower and lender households in the Australian economy, the average borrower holds two to three times as much net debt as the average lender holds in net liquid assets. Another reason is that the sensitivity of spending to changes in interest-sensitive cash flow is estimated to be larger for borrowers than for lenders based on statistical analysis using household-level data.
Overall, the estimates suggest that the cash flow channel is an important channel of monetary transmission; the central estimates indicate that lowering the cash rate by 100 basis points is associated with an increase in aggregate household income of around 0.9 per cent, which would, in turn, increase household expenditure by about 0.1 to 0.2 per cent through the cash flow channel.
We have a couple of issues with their analysis. First, recent events have shown that when the cash rate is cut, the benefit is not necessarily passed through to households, thanks to weak competition in the banking sector. When it is, the benefit is often not equally shared between borrowers and savers, and not all savers benefit equally. In fact, looking at the trends in recent years, savers have been taken to the cleaners, as banks repair and protect their margins. So benefits are overstated.
The second issue is households will be impacted by the confidence surrounding a rate move. If they become less confident, they will be less likely to spend, preferring to save for later. So a rate cut often lowers household spending – this is one of the significant reversals we have seen recently – and central banks are still trying to get to grips with the implications. The link between low interest rates and household spending, yet alone broader economic growth appears broken.
So, whilst the article is a good attempt, we think it overstates the benefits of cash rate cuts in the current cycle.
