Christopher Kent: Monetary policy transmission - what's known and
what's changed
Public lecture by Mr Christopher Kent, Assistant Governor (Economic) of the Reserve Bank
of Australia, at the Australian National University, Canberra, 15 June 2015.
* * *
Accompanying charts can be found on the Reserve Bank of Australia's website.
I thank Laura Berger-Thomson, Adam Cagliarini, Gianni La Cava and Matthew Read for excellent suggestions
and assistance in preparing these remarks.
1. Introduction
I'd like to thank Rohan Pitchford and Martin Richardson for organising this event. It's great to
be back at the ANU, where almost 30 years ago I was embarking on my study of botany just
across campus, with some economics on the side for good measure. It was my dislike of
compulsory chemistry classes led me down that side path.
Tonight I want to talk about the effects of monetary policy on the economy. Interest rates
have been at very low levels for some time. Yet economic growth is below trend, the
unemployment rate is relatively high and domestic inflationary pressures are well contained.
This is expected to remain the case for a time. It's natural then to ask whether monetary
policy is less effective than in the past.
Almost 20 years ago, Stephen Grenville, who was in my current role at the time, gave a
comprehensive account of what we knew and didn't know about the transmission of
monetary policy in Australia.1 The structure of the economy has changed since then in ways
that may have altered the transmission mechanism.
So it is timely on two counts to consider how the monetary policy transmission mechanism is
operating in the current environment.
2. How monetary policy works (in theory)
2.1 Overview of the transmission mechanism
In responding to cyclical developments and inflation pressures, monetary policy has a
significant influence on aggregate demand and inflation. The transmission of interest rates
through the economy can be roughly described as follows. I'll focus on an easing of
monetary policy.
1. The Reserve Bank lowers the overnight cash rate.
2. Financial markets update expectations about the future path of cash rates and the
structure of deposit and lending rates are quickly altered.
3. Over time, households and firms respond to lower interest rates by increasing their
demand for credit, reducing their saving and increasing their (current) demand for
goods, services and assets (such as housing and equities).
4. Other things equal, rising demand increases the prices of non-tradable goods and
services. The price-setting behaviour of firms depends on demand conditions and
the cost of inputs, including of labour. Higher aggregate demand leads to increased
labour demand and a rise in wages.
The transmission mechanism depends crucially on how monetary policy affects households'
and firms' expectations. Expectations about the future path of the cash rate will affect
financial market prices and returns, asset prices and the expected prices of goods, services
and factors of production (including labour). Expectations of more persistent changes in the
cash rate will have larger effects.
The extent to which lower interest rates lead to extra demand will depend on how
households and businesses alter their behaviour regarding borrowing and investing, as well
as consuming and saving. These responses are often described as occurring via a number
of different channels.
2.2 How interest rates affect demand - various channels
The exchange rate channel is one way in which interest rates affect demand. Lower interest
rates contribute to an exchange rate depreciation by reducing returns to, and hence the
demand for, domestic assets relative to foreign currency-denominated assets. A depreciation
increases the prices of foreign products relative to domestic products. This leads to a
switching of demand towards domestically produced goods and services. (A lower exchange
rate also leads directly to an increase in import prices.)
Many macroeconomic models emphasise intertemporal substitution as the primary
transmission channel. Households and businesses make decisions about whether to save
more or less now so as to spend more or less later. Lower interest rates provide less reward
for saving, thereby encouraging more expenditure in the near term (and less further out).
Decreases in interest rates will boost asset prices, which can have a number of effects. First,
it boosts investment in housing, equipment and other capital goods as it becomes less
expensive to build than to buy (this is likely to be important, although empirical evidence of
the relevance of the 'q-ratio' is weak). Second, households typically respond to an increase
in their net worth by consuming a little more at each point in time. This is known as the
wealth channel, which appears important in the Australian context. The balance sheet
channel is closely related. Rising net worth makes it easier to borrow, with higher collateral
values making lending a less risky proposition.
The cash-flow channel appears to be an important part of the transmission mechanism in
Australia. Changes in interest rates affect households' and businesses' cash flows. If they
face liquidity or borrowing constraints, an increase in cash flows will typically lead to more
spending.2 For example, a decrease in interest rates lowers interest payments for
households with variable-rate mortgages, leaving them with more disposable income to
spend. At the same time, cash flows will be lower than otherwise for those with
interestearning assets and they may choose to restrict their spending. Notwithstanding this latter
effect, decreases in interest rates can be expected to increase demand through this channel.
This reflects the fact that the household sector in Australia is a net borrower, by which I mean
that its interest bearing liabilities are greater than its interest-earning assets.3 Moreover, it
seems plausible that marginal propensities to spend are generally higher for debtors (who
may face credit constraints) than for creditors.
That's a rough sketch of the theory of the transmission mechanism. What can we say about it
in practice and how might it have changed over time?
3. Estimates of the overall effect of monetary policy
It is difficult enough to estimate the strength of the monetary policy transmission mechanism
in terms of its effect on the economy overall. It is harder still to separately identify the
strength of each of the various channels. A key challenge is disentangling the effect of
monetary policy from other influences, such as foreign developments or changes in fiscal
policy. This requires models that simultaneously account for these and other forces.
There are a wide range of model estimates from which to choose, each capturing different
aspects of the ways in which the world works in reality. For illustrative purposes, let me
mention just one set of recent estimates provided by some of my colleagues using a
socalled Dynamic Stochastic General Equilibrium (DSGE) model.4 Consider the estimated
effects of a decrease in the cash rate of 100 basis points. This will lead GDP to be higher
than otherwise by between about 1⁄2 and 3⁄4 of a percentage point over the course of two
years (Graph 1). Inflation is estimated to rise by somewhat less than 1⁄4 percentage point per
annum over 2-3 years. These estimates are close to those of other models.5
Estimates from this DSGE model tentatively suggest that the overall effect of monetary policy
has not changed significantly in recent years. In particular, estimates of the 'endogenous'
relationships in the model based on data up to 2008 (after which interest rates have been
notably lower) are about the same as estimates based on data to the present day. This
suggests that the period of below-trend growth in GDP over the past few years may not
reflect a change in the monetary policy transmission mechanism. Rather, the model
attributes below-trend growth to sizeable exogenous forces or shocks. The sharp fall in
commodity prices has played an important role of late. Also, weakness in private investment
- beyond that which can be explained by subdued domestic demand and falling commodity
prices - has made a sizeable contribution to below-trend growth. The model also suggests
that consumption growth has been a bit weaker than in the past.
These estimates provide some tentative evidence that the overall effect of monetary policy is
neither more nor less effective than in the past. However, it may be that it's too early to
identify any structural change with the data to hand. Alternatively, the effect of monetary
policy on overall activity and inflation might be close to its historical average, but this could
mask changes in its effects across different parts of the economy or variation in the relative
strength of the different channels from one episode to the next.
4. Estimates of some channels of monetary policy
I'll consider this possibility by looking more closely at the behaviour of dwelling construction
and household consumption. I'll leave to one side the effects of monetary policy on business
investment and external trade.6 I'd note though that a further rise in the growth rate of
household expenditure should contribute, in time, to a pick-up in non-mining business
investment. So too would a further depreciation of the exchange rate, which would raise the
demand for domestic production. We have argued that a further exchange rate depreciation
appears likely and necessary, particularly given the large declines in commodity prices this
year.
4.1 Responsiveness of dwelling construction
Dwelling construction is typically the most interest-rate sensitive component of expenditure in
the Australian economy. It is growing strongly in response to low interest rates, rising by
about 9 per cent over the past year (Graph 2).
The results of a standard 'single-equation' reduced-form model suggest that the response (to
date) of residential building approvals to lower interest rates and higher housing prices is
broadly consistent with historical experience.7
Although the behaviour of construction investment over the past few years is not unusual, it
is possible that with a period of very low rates there will be some limit as to how much
demand for dwelling construction can be brought forward from the future.
It is also possible that a period of very low interest rates will eventually lead to higher inflation
for land and construction work, as is normally required to bring forth more supply of a
particular good or service. These pressures might arise from a depletion of suitable land
available for development or a need to attract more developers and workers into the industry.
In such circumstances, any further increases in construction demand would tend to push up
prices of existing and new dwellings. This could occur via increases in land prices,
construction wages, developers' margins or some combination of all three. The direct effect
of additional demand for construction on economic activity would be less than in the case of
ample spare capacity. But such a situation would still provide support to aggregate demand
in other ways, including via the operation of the balance-sheet and wealth channels.
There is evidence of some tightening in supply in pockets of the country. In some cities,
stocks of unsold lots suitable for development appear to be unusually low (Graph 3).
Shortages are most evident in Sydney, where greenfield land releases have not kept pace
with recent strong demand. Also, some of the Bank's liaison contacts are concerned that the
stock of suitable sites for apartment developments in Sydney has been depleted in the past
few years.
There is little evidence of labour supply constraints outside a few trades and professional
roles. However, inflation of building material prices has risen and the Bank's liaison suggests
that some builders have increased margins over the past year or so. Consistent with this,
inflation in new dwelling costs has risen to be almost 2 percentage points above its average
over the inflation-targeting period; although, it is still below that seen when dwelling
construction was strong in the early 2000s.
Despite the potential emergence of some constraints affecting the supply of new dwellings in
pockets of the country, there appears to be scope for strong growth in new dwelling
construction in other parts of the country. Moreover, alterations and additions activity could
pick up. This used to account for about 45 per cent of total dwelling construction, but has
declined over the past few years, despite lower interest rates and the sizeable increase in
dwelling prices.
In short, there are some signs of tightening supply conditions in pockets of the country, but
dwelling construction overall is responding to low interest rates much as it always has done.
4.2 Consumption and the behaviour of borrowers and savers
What about the effect of low interest rates on household consumption?
This can be modelled in a simple way by linking household consumption to disposable
income and household wealth. In such a model, lower interest rates affect consumption
indirectly by increasing household disposable income and boosting both housing and equity
prices.8
This simple model (like the DSGE model results I discussed) provides some tentative
evidence that consumption growth has been a bit weaker over recent years than suggested
by historical experience. Much of that history, however, captures the period of adjustment to
easier access to credit from the early 1990s to the mid 2000s. At that time, household
indebtedness increased substantially and the saving ratio declined to be well below earlier
norms (Graph 4).9 So in a way, the more recent experience could be regarded as the more
standard response. Indeed, the behaviour of late appears more sustainable than that of the
previous episode.10
One aspect of this change in behaviour is evident in households injecting equity into the
housing stock over recent years. That is, their net new spending on housing assets has
exceeded their borrowing secured over housing. This stands in stark contrast to the period of
strong housing market conditions in the first half of the 2000s, which saw households
withdrawing housing equity to help finance their consumption (Graph 5).11
As I just mentioned, the experience of recent years is characterised by slightly lower growth
of consumption than might have been expected. However, the responsiveness of
consumption to disposable incomes and wealth does not appear to have changed, at least in
a statistically significant way.
There are two possible explanations for this observation. First, the growth of consumption of
late could be affected by factors other than the stance of monetary policy. Second, it may be
that the strength of the various monetary policy transmissions channels affecting
consumption has changed, but in ways that are difficult to identify using models of aggregate
household behaviour. Although it is hard to be definitive, my sense is that both these
explanations are likely to be true.
8
Estimates of wealth effects tend to differ somewhat based on the exact data and methodology used in their
estimation. Previous work by Bank staff suggests that households consume between 3 and 4 cents out of
every extra dollar of housing wealth. For examples, see Dvornak N and M Kohler (2003), 'Housing Wealth,
Stock Market Wealth and Consumption: A Panel Analysis for Australia', RBA Research Discussion Paper No
2003-07 and Windsor C, J Jääskelä and R Finlay (2013), 'Home Prices and Household Spending', RBA
Research Discussion Paper No 2013-04.
9
See RBA (2014), Submission to the Financial System Inquiry, March, Chapter 2.
10
See Stevens G (2013), 'Economic Policy after the Booms', Address to The Anika Foundation Luncheon,
Sydney, 30 July.
11
For a description of housing equity withdrawal, see Schwartz C, T Hampton, C Lewis and D Norman (2006),
'A Survey of Housing Equity Withdrawal and Injection in Australia', RBA Research Discussion Paper No
2006-08.
Let me start with changes affecting the cash-flow channel. Net interest payments of
households are now more responsive to changes in interest rates than they were a decade
or more ago (at least in the short term). To illustrate the magnitude of this, we can estimate
the effects of a 100 basis point reduction in the cash rate on net interest payments (as a
share of household disposable incomes; Graph 6).12
There has been a noticeable increase in households' holdings of interest-earning assets
(such as bank deposits) over recent years (Graph 7). But despite this, a reduction in interest
rates still lowers households' net interest payments, and by much more than was the case in
earlier decades. This larger response reflects the substantial increase in housing credit from
the early 1990s to the mid 2000s.
By itself, the greater responsiveness of net interest payments implies that the cash-flow
channel should be stronger now than it was previously. Other things equal, we might have
expected that the stronger effect of interest rates on the average household's cash flows,
and the operation of the other channels of monetary policy, would have encouraged a more
noticeable rise in debt and a larger increase in current consumption in response to very low
interest rates. Yet household indebtedness has been relatively stable for some years now
(Graph 7 and Graph 9). While low interest rates may have helped to support consumption
and debt, other forces appear to have been working in the opposite direction. Moreover, the
response of consumption and indebtedness will depend on how different types of households
are responding to these forces. Let me make this clearer with some examples.
Some households may have revised down their expectations for income growth and may
also be more uncertain about their incomes. This would be consistent with the substantial
decline in wage growth and the rise in the unemployment rate over the past few years.13 This
could have caused some households to have become uncomfortable with the levels of debt
that they had been carrying. Accordingly, many households may have decided to pay down
their debts faster than they would have in a world of unchanged expectations about incomes,
thereby contributing to a period of weaker consumption growth. In such an environment,
lower interest rates help to facilitate 'deleveraging', hastening the time at which those
households will feel more secure about their financial situation.
There is evidence of many households behaving in this way. In particular, the rate of
mortgage prepayments has increased as interest rates have fallen and more households are
15
well ahead of their required schedule of repayments (Graph 8).14,
Also, if we deduct funds held in mortgage offset accounts and ignore investor credit, we can
see that the rest of household credit has declined by about 4 percentage points as a share of
household disposable income since early 2010. This is consistent with a degree of
deleveraging among some households, particularly when we consider that low interest rates
12
This chart estimates the reaction of cash flows to the cash rate change within a month. Since a larger share of
deposit rates are fixed than are loan rates, this will overstate the effect on cash flows over longer time
horizons, though the extent of this bias has not necessarily changed over time in an obvious way.
13
Jacobs D and A Rush (2015), 'Why is Wage Growth So Low?', RBA Bulletin, June, forthcoming.
14
A lack of data means that we cannot make comparisons to earlier easing phases when indebtedness was
lower.
15
Another factor potentially muting the response of consumption to interest rate changes relates to banks'
processes for adjusting scheduled mortgage repayments following changes in lending rates. Some banks do
not decrease scheduled mortgage repayments when interest rates decrease. This means that even though
the interest component of the repayment has declined, the total repayment is the same, resulting in many
borrowers automatically making excess principal repayments. See Thurner M-O and A Dwyer (2013), 'Partial
Mortgage Prepayments and Housing Credit Growth', RBA Bulletin, September, pp 31-38.
might otherwise have encouraged a general increase in this type of credit over that period
(Graph 9).16
What about those households that rely on interest-bearing assets? Their disposable incomes
are lower than otherwise given the sizeable decline in interest rates.17 Accordingly, such
households may be reluctant to maintain consumption by either running down their pool of
liquid assets, or accessing capital gains they may have enjoyed on any housing or equities
that they hold. Such behaviour would contribute to the growth of aggregate consumption
being less responsive to a decline in interest rates than in the past.
Finally, let's consider those households with some spare funds to invest. The very low level
of interest rates may have prompted such households to search for yield. Many of these
households have combined those spare funds with new debt to purchase housing for the
purposes of investment. Indeed, the strong growth of investor housing loans has driven the
growth in household debt (as a share of disposable incomes) over recent years and
contributed to a rise in both housing prices and dwelling construction. While this may not
directly contribute to a rise in consumption of households undertaking the investment, it will
support overall economic activity nonetheless.
Conclusions
Monetary policy is clearly working to support demand, although it is working against some
strong headwinds. These include the significant decline in mining investment, fiscal
consolidation at state and federal levels and the exchange rate, which continues to offer less
assistance than would normally be expected in achieving balanced growth in the economy.
Model estimates that control for these and other forces provide tentative evidence that the
monetary policy transmission mechanism, in aggregate, is about as effective as usual.
However, it may be too early to pick up a statistically significant change using such models.
As usual, dwelling construction is growing strongly in response to low interest rates, and this
is making some contribution to the growth of aggregate demand and employment. It may be
that in parts of the country, any further substantial increases in residential construction
activity might run up against some supply constraints, putting further upward pressure on
housing prices. As the Bank has noted for some time now, large increases of housing prices,
if accompanied by strong growth of credit and a relaxation of lending standards, are a
potential risk for economic stability. Accordingly, the Bank is working with other regulators to
assess and contain such risks that may arise from the housing market.
Consumption growth has picked up since 2013. But it is still a little weaker than suggested by
historical experience. This may reflect a number of factors including some variation in the
ways that the different channels of monetary policy are affecting households according to
their stage in life. Some indebted households appear to be taking advantage of low interest
rates to pay down their debts faster than has been the norm, perhaps in response to weaker
prospects for income growth. Those relying on interest receipts may feel compelled to
constrain their consumption in response to the relatively long period of very low interest
rates. Meanwhile, the search for yield is no doubt playing a role in driving the strong growth
of investor housing credit. This might provide some indirect support to aggregate demand,
but this channel is not without risk.
In short, monetary policy is working. The transmission mechanism may have changed in
some respects, and this could help to explain lower-than-expected growth of consumption
and debt of late. But it is hard to be too definitive. To know more about this, it would be
helpful to better understand the behaviours of different types of households using
householdlevel data. To use a botanical analogy, to know more about a plant, it's helpful to observe
how its different types of cells work.