I want to thank Bloomberg for organising this event. Its great to be back at this venue.
Since May 2022, the Reserve Bank has raised the cash rate target by 400 basis points with the goal of
bringing inflation back into its target range of 2–3 per cent. Tighter monetary policy is working to slow the
growth of demand and bring it into better balance with supply. This is contributing to the decline in
inflation.
Today I want to show how increases in the Banks cash rate target are transmitting through to demand
and inflation. The most well-known element is the cash-flow channel, whereby a rise in the cash rate
leads to higher interest payments for those who have debt, reducing the income borrowers have to spend on
other things, leading to slower growth of demand and ultimately a decline in inflation.
The cash-flow channel is felt with immediacy by borrowers with variable-rate debt and then with a lag for
those with fixed-rate debt. It is this channel that is being felt most keenly at present, with many
indebted households and businesses experiencing a painful squeeze on their finances. While this burden
falls on only part of the population, there are other channels of monetary policy that spread across a
broader range of people. Indeed, in economies such as the United States where a sizeable share of
borrowing – particularly mortgages – is at rates fixed over very long periods, these other
channels of monetary policy do most of the heavy lifting.
My talk today will focus on how monetary policy moves through the economy in three steps – from the
cash rate to a broad range of interest rates, from those rates to economic activity and from economic
activity to inflation. I will discuss the five main channels of monetary policy and the impact these are
having in Australia to bring down inflation.
Step 1: From the cash rate to other interest rates
The cash rate is the interest rate paid by banks that borrow from other banks in the overnight market. It
is closely linked to other interest rates throughout the economy. When banks borrow at slightly longer
terms – of say a month – they pay a similar rate of interest (to what they expect the cash
rate to be over that time). If they faced a much higher rate, they would be better off borrowing
overnight in the cash market and rolling that each day for the month. Going the other way, banks can
leave spare cash with the RBA at the Exchange Settlement (ES) rate, which is just below the cash rate
target. As such, they will be willing to lend spare cash to other banks so long as they get more than the
ES rate in return.
For these reasons, short-term interest rates are closely linked to the cash rate (Graph 1).
Australian banks typically fund themselves with debt that pays interest linked to short-term interest
rates – the three-month bank bill swap (BBSW) rate to be precise. Therefore, changes in the cash
rate have a direct effect on banks funding costs. Banks pass this on to borrowers with
variable-rate debt.
Graph 1
Banks have also passed on much – though not all – of the rise in the cash rate to depositors.
Since May 2022, Australian banks have passed on about 75 per cent of the increase in the cash
rate to deposits, which is in line with past phases of rising interest rates. In fact, the extent of this
pass-through to deposit rates has been relatively high compared with other economies (Graph 2). In
New Zealand, for example, the equivalent figure is about 50 per cent, while in the United
States it is about 35 per cent. Among other things, this difference may reflect Australian
banks focus on variable-rate borrowing and lending.
Graph 2
The link to the cash rate is not as tight for longer term interest rates. A higher cash rate usually
results in long-term interest rates and yields rising, but by less than the cash rate. This is because
other factors affect long-term rates, including yields offshore and expectations for the cash rate and
inflation beyond the near term.
Longer term yields are more important for the transmission of monetary policy in some economies such as
the United States, where a lot of borrowing is at long-term fixed rates. They are much less important in
countries like Australia where most borrowing is variable rate.
That said, because changes in long-term interest rates have important effects on the valuations of other
assets like equities, corporate bonds and the exchange rate, they are still relevant to the transmission
of policy in Australia. I will come back to this point later.
Step 2: From interest rates to economic activity
Economists typically think of five channels through which monetary policy – via both current and
expected future policy rates – affects economic activity and inflation. These are:
- the cash-flow channel
- the intertemporal substitution channel
- the asset-price channel
- the credit channel
- the exchange rate channel.
The cash-flow channel
When interest rates go up, households pay more on their debt and earn more on their savings. Because the
cash-flow channel is so noticeable, and felt so keenly by borrowers, it gets a lot of attention,
particularly in Australia where most borrowing and much saving is done at variable rates. And even for
borrowing that is at fixed rates, these tend to be for three years at most, which is short compared with
many other economies.
Since last May, required household mortgage payments – interest plus scheduled principal repayments
– have risen from around 7 per cent of household disposable income to almost
10 per cent. This is above estimates of the peak reached in 2008 when the cash rate was
7¼ per cent. And for those households with a large mortgage, required payments are a much
higher share of their income.
Required payments will continue to rise a little further in the period ahead as fixed-rate loans taken out
during the pandemic reach the end of their fixed-rate period. The share of such loans has already fallen
substantially, from close to 40 per cent in early 2022 to about 20 per cent today.
Many borrowers have had to cut back on spending to meet higher mortgage payments, while also feeling the
pain of rapidly rising living costs. This has led to slower growth in demand for goods and services.
Businesses with high levels of debt may also have reined in their investment spending.
Conversely, households that have savings are now earning more interest and may spend more in response. To
some degree, this counterbalances the households that are spending less. However, the stock of household
debt in Australia is larger than the stock of household savings. Since rates have been rising, the
contribution of interest received by those with savings to the growth of disposable income (the yellow
bars in Graph 3) has been noticeably smaller than the extra interest payments made by those with
debt (in orange). Moreover, people with savings typically spend less of each extra dollar they earn than
those with debt, so any additional spending associated with extra interest received is not enough to
offset the reduction in spending associated with extra interest paid.
Graph 3
Our estimates suggest that the 4 percentage point increase in the cash rate target since May 2022
will have reduced overall household spending by around 0.4–0.8 per cent per year through
the cash-flow channel. Studies imply similar-sized effects in other countries with high levels of
variable-rate debt.
Again, the cash-flow channel is less prominent in economies where most debt is locked in at fixed rates
for lengthy periods (Graph 4). In the United States, mortgages are typically fixed for
30 years. That said, when rates are falling, existing US borrowers tend to refinance, while rising
interest rates dampen the demand for new loans and turnover in the housing market declines, thereby
reducing a range of associated spending. Monetary policy is still effective in such economies, including
through the cash-flow channel, but it operates more intensively via other channels.
Graph 4
The intertemporal substitution channel
Changes in interest rates also affect the incentive to spend versus save, through what is known as the
intertemporal substitution channel (or the savings-investment channel). For businesses, the interest rate
affects the cost of capital, which helps to determine whether and when theyll invest. For
households, higher interest rates provide an incentive to save more today and postpone consumption and
dwelling investment until another time.
There is mixed evidence on the extent to which interest rates affect business investment in Australia
directly. It can be difficult to find a relationship in the aggregate data. But
studies using firm-level data do suggest that business investment responds to changing interest
rates.
Recent Bank model estimates imply that the 4 percentage point increase in the cash rate might
contribute to business investment being around 4 per cent lower than otherwise after two to
three years.
Dwelling investment typically responds quickly to changes in interest rates. Fewer homes are built and
renovation activity declines when interest rates rise noticeably (Graph 5). This is the
intertemporal substitution channel at work – people are saving their money and putting off major
spending to a later date. That said, the asset-price and credit channels are also likely to be at play
here.
Graph 5
In the current cycle, higher interest rates may have also played a role in slowing the rate at which many
households have run down the sizeable stock of additional savings accumulated during the pandemic. This
would contribute to slower growth of consumption than otherwise. In fact, the household savings ratio in
Australia has only recently dipped below the pre-pandemic average after having been well above that for
most of the pandemic period (Graph 6).
Graph 6
The asset price channel
A rise in interest rates contributes to lower asset prices. This is because asset prices – for
shares, bonds and housing – depend on the discounted value of the expected future cash flows such
assets produce (namely, dividends, coupon payments and rental income). A rise in interest rates increases
the discount factor and hence lowers asset prices and in turn household wealth. While
details vary, empirical studies suggest that changes in wealth lead to changes in consumption. For
Australia, various estimates suggest that each 1 per cent decline in wealth results in a fall
in consumption of around 0.1–0.2 per cent, well within the range of estimates for other
countries.
However, other factors also have an impact on asset prices. Indeed, while housing prices in Australia
declined during the initial period of monetary policy tightening through 2022, they have been rising over
much of this year even though credit growth has slowed and monetary policy has been tightened further.
This is likely to owe, at least in part, to the surge in population growth combined with a relatively low
level of new construction.
The credit channel
Higher interest rates can also reduce the supply of loans to households and the availability of external
funding to businesses, via the credit channel. Higher interest rates tend to make lending more risky,
especially to lower net worth borrowers. It also makes it more costly for businesses to borrow at a time
when weaker economic conditions are weighing on their ability to generate profits (which could otherwise
help them to fund investment). Increases in the riskiness of the underlying loans will also raise
banks funding costs.
To the extent that some households and businesses are offered smaller loans than they would otherwise have
preferred, and on less favourable terms, this will result in less borrowing and so slow the growth of
overall demand.
One way the credit channel operates in Australia is via the serviceability assessment that banks apply
when deciding how much to lend to prospective borrowers. Under these assessments, the increase in the
cash rate since May 2022 has seen the borrowing capacity for a typical household fall by around
30 per cent. Accordingly, housing loan commitments have fallen by
around the same amount since early 2022, although other factors such as lower demand for credit may also
be playing a role (Graph 7).
Graph 7
The exchange rate channel
The exchange rate channel can be important, particularly for a small open economy like Australia.
All else equal, a rise in Australian interest rates relative to interest rates offshore increases the
demand for Australian assets and so increases the value of the Australian dollar. By itself, an
appreciation of the Australian dollar will reduce the prices Australians pay for foreign goods and
services, and increase the prices foreigners pay for goods and services produced here. So an appreciation
of the Australian dollar would contribute directly to lower Australian inflation via lower prices for
imports. It would also encourage both Australians and foreigners to divert some of their spending from
goods and services produced here to those produced offshore. In the context of high inflation and demand
that is greater than the economys capacity to supply goods and services, this diversion of spending
offshore would be helpful.
But of course all else is not equal. While Australian interest rates have been rising to combat inflation,
interest rates overseas have been rising for the same reason. As a result, despite increases in
Australian interest rates from May 2022, the Australian dollar has depreciated by just a little more than 2 per cent on
a trade-weighted basis since then. Other global developments have also played a role. In particular, over
recent months there have been rising concerns about the economic outlook for China, which is a major user
of Australian commodities and is our largest trading partner. Nevertheless, by raising the cash rate,
monetary policy has helped to support the value of the Australian dollar in the face of these other
influences.
Step 3: From economic activity to inflation
The first step of the transmission of the cash rate to other interest rates and the exchange rate is
quick. The second step takes time, with changes in interest rates affecting the growth of demand via the
various channels Ive discussed. The third step – the link to inflation – takes longer
still, with growth in demand typically slowing before theres a broad-based reduction in inflation.
The past year or so has been an exception to this, given that some of the sharp increase in inflation and
then subsequent decline has reflected problems in global supply chains that are now resolved or
improving. Nevertheless, the effect of slower demand growth on inflation is now building. For example, we
are hearing in liaison that a range of retailers are discounting prices in the face of weak consumer
spending.
Which channel matters most?
It is difficult to gauge the strength of these different channels because they operate at the same time
and we only observe the net effects. However, there is empirical evidence for the
importance of each channel on elements of demand and/or inflation. We also know that monetary policy is
effective in countries that have a much weaker cash-flow channel than Australia. For example, the
significant increase in policy rates in Australia and the United States are contributing to broadly
similar changes in key macroeconomic indicators. In particular, growth in domestic demand has moderated
in both economies. Labour market conditions are easing as indicated by the decline in job vacancies as a
share of unemployment. And inflation has declined, including in core terms.
Graph 8
Conclusion
The cash-flow channel is the obvious way in which monetary policy is transmitted to aggregate demand and
inflation in Australia. Compared with earlier episodes of rising interest rates, this channel has been
operating with a slight delay given the high initial share of fixed-rate loans. But around half of all
loans that were fixed at a low rate have now rolled off, and most of the rest will do so over the next
12 months. Required mortgage payments are at a record share of household disposable income and will
rise further as more fixed-rate loans expire.
The cash-flow channel is felt acutely by those with variable-rate debt. But there are other important
channels of monetary policy. In particular, the rise in interest rates has increased incentives to save.
This is true even for households that had built up a lot of extra savings during the pandemic. Households
with debt also have an incentive to save more; some may be able to pay down their debts ahead of schedule
or at least run down their savings buffers more slowly than otherwise.
These and the other channels of monetary policy are slowing the growth of demand and contributing to a
decline in inflation. The lags of transmission mean that some further effects of rate increases to date
are still to be felt through the economy, which will provide further impetus to lower inflation in the
period ahead. Meanwhile, the Board is paying close attention to economic developments here and overseas,
and some further tightening of monetary policy may be required to ensure that inflation, which is still
too high, returns to target in a reasonable timeframe.
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