Speech

The cash-flow channel of monetary policy - micro evi-
dence and macro outcomes

Remarks by Governor Ida Wolden Bache at the 2024 Jackson Hole Economic Policy
Symposium

Introduction

Good morning. I want to start by thanking the Federal Reserve Bank of Kansas City
for the invitation and for giving me the opportunity to be part of this year's policy-
maker panel. It's a pleasure to be here.

The tightening of monetary policy by central banks over the past few years has been
unprecedented in several respects. Chart 1 shows the policy rates for a selection of
developed economies. By some measures, the current tightening has been the
most globally synchronized of all tightening episodes in the past half century.[1]

And still - the macroeconomic effects of this tightening may vary considerably
across countries. My remarks today will focus on one particular aspect of the mone-
tary policy transmission mechanism, namely the cash-flow channel from interest
rate changes to household consumption.

I want to make three main points. The first one is that the cash-flow channel is quan-
titatively important, but its strength varies widely both over time and across coun-
tries depending on the composition of household balance sheets and on institu-
tional features of mortgage markets. Second, high quality microdata are essential
for gaining insight into this part of the transmission mechanism. And third, the
strength of the cash-flow channel has implications for the trade-offs we face as
monetary policymakers, especially in small, open economies.

The cash-flow channel of monetary policy

In what follows, I will refer to the cash-flow channel as the direct effect of monetary

policy on household spending operating through net interest expenses.[2] The
(Qsh-tlow channel is likely to be stronger when households are more indebted and

when interest rates on outstanding debt are tightly linked to short-term rates. Chart
2 illustrates the extent of variation in the household debt-to-income ratio and the
share of adjustable-rate mortgages across countries.[3] In Norway, where 95 per-
cent of home loans have an interest rate that moves in tandem with short-term
money market rates and the average household debt-to-income ratio is among the
highest in the world, there is a fast and strong pass-through of policy rate hikes to
household disposable income.[4] In the US, where fixed-rate mortgages account for
more than 90 percent of home loans, most of them with an initial 30-year fixation
period, and the average household is less indebted than in Norway, the pass-
through of higher policy rates to borrowing costs can be expected to be much
smaller in the short run.

In fact, while the policy rate has increased by more in the US than in Norway during
the current tightening cycle, interest payments as a fraction of income has in-
creased by much more in Norway, as you can see in Chart 3. If we were to subtract
interest income, the difference would be even more stark.[5]

Looking at these charts, I think it is obvious why it has been a priority for Norges
Bank to understand just how strong the cash-flow channel is. And fortunately, new
high-quality data has made that possible. We have recently assembled a new and
unique dataset that combines rich information on household balance sheets and in-
come from tax returns with directly measured consumption expenditures from indi-
vidual electronic transactions for all residents of Norway.

Using this dataset, my colleagues have estimated how much the responsiveness of
consumption to interest rates varies with household indebtedness.[6] Chart 4
shows the change in consumption following a one percentage point unexpected in-
crease in the policy rate and how that varies with a household's gross debt-to-in-
come ratio. As we can see, the consumption response to a policy tightening in-
creases with indebtedness.[7] These effects set ina couple of months after the in-
terest rate hike and increase over the course of the first year. If we compare a
household with a debt-to-income ratio of three to a household with no debt, the in-
debted household will cut spending by around 1.5 percentage points more after one
year.[8]

We can also see from Chart 4 that the consumption response increases almost lin-
early with a household's debt-to-income ratio. The implication is that the strength of
the aggregate cash-flow channel only depends on the total debt-to-income ratio for
all households in the economy, not on the distribution of debt across households.[9]
This begs the question: does a central bank need to know how monetary policy
transmission works at the micro level? After all, we already have plenty of evidence
on the macroeconomic effects of monetary policy.[10] I will argue that the kind of
evidence I have presented is still valuable.

First, itis important for policymakers to understand - and communicate to the wider
public - how actual people, not just macroeconomic aggregates, are affected by
our actions.[11]

Second, while it is true that the average effects of monetary policy over a historical
period can be estimated based on macroeconomic data, they are a poor guide to
how transmission works today if relevant states of the economy are very different
from the past. And in fact, those states have changed quite a lot in recent decades.
As illustrated in Chart 5, households' debt-to-income ratios have increased
markedly in many countries over the past quarter century.[12] In Norway, household
debt increased from around 120 percent of disposable income in 1995 to almost 250
percent in 2021. A back-of-the-envelope calculation based on our microdata esti-
mates suggests that, due to this increased indebtedness alone, aggregate con-
sumption will fall by around 50 basis points more in reaction to a one percentage
point contractionary monetary policy shock now than in the 1990s.[13] That amounts
to as much as a two thirds increase in the interest rate effect on household spend-

ing.[14]

Research on microdata can also help us to understand how the transmission of
monetary policy is affected by the types of mortgages households have. In the
decade or so following the end of the Great Financial Crisis, fixed-rate mortgages
became more common around the world.[15] When fixed-rate mortgages are the
norm, the cash-flow channel is asymmetric. A lower policy rate can pass through rel-
atively quickly to average mortgage rates, at least when there are no prepayment
penalties and when most people save money by refinancing at the lower rate.[16] A
higher policy rate, on the other hand, has a more muted effect on average mortgage
rates in the short run. So, as fixed-rate mortgages become more common, the cash-
flow channel becomes weaker for contractionary monetary policy. How much

weaker obviously depends on the fraction of mortgages that are fixed-rate and how
long the average fixation period is. But the microdata estimates I showed you earlier
indicate that if a country with a household sector debt-to-income ratio of 100 per-
cent were to go from having only floating-rate debt to only long-term fixed-rate
debt, then all else equal, a one percentage point contractionary monetary policy
shock would lower consumption by around 40 basis points less in the short run.[17]

Policy consequences of a strong cash-flow channel

Now, a third reason why it is essential to know the details of how transmission works
is that it can have implications for how we conduct policy. That is particularly the
case in small, open economies.

In open economies, monetary policy affects inflation both through the aggregate
demand channel and through the exchange rate channel. A higher interest rate low-
ers demand directly, and lower demand leads to lower domestic inflation. A higher
interest rate normally also leads to an exchange rate appreciation and thereby
lower imported inflation. The relative strengths of these channels affect the mone-
tary policy trade-offs.

Let us take the example of a small, open economy that is hit by an inflation shock.
According to the textbook theory, the central bank should increase the interest rate
to bring inflation gradually back to target. A higher interest rate dampens aggregate
demand, which might be necessary to bring inflation down. If the aggregate de-
mand channel is strong compared with the exchange rate channel, for instance be-
cause cash-flow effects on consumption are important, a larger reduction in output
is needed to achieve a given disinflation.[18] That is because more of the disinflation
will come through lower output and employment and less through lower imported
inflation. In countries where the effects of monetary policy on aggregate demand
are weaker, the central bank gets more help from the exchange rate in bringing in-
flation down, and inflation can be stabilized at lower employment costs.[19]

So, let me end with this. The fact that we have a relatively strong cash-flow channel

in Norway does affect the monetary policy trade-offs. And while a strong cash-flow
channel can prove beneficial in some situations, in others it can make stabilizing in-
flation more costly. These costs matter for how fast we aim to bring inflation back to

target. But let there be no doubt: these costs do not prevent us from setting an in-
terest rate consistent with bringing inflation back to target within a reasonable time
horizon.

Thank you.

Sources

Ahn, SeHyoun, Sigurd Galaasen, and Mathis Meehlum (2024) «The Cash-Flow
Channel of Monetary Policy - Evidence from Billions of Transactions». Unpublished.

Amberg, Niklas, Thomas Jansson, Mathias Klein, and Anna Rogantini Picco (2022)
«Five facts about the distributional income effects of monetary policy shocks».
American Economic Review, 4 (2), September, pages 289-304.

Andersen, Asger Lau, Niels Johannesen, Mia Jorgensen, and José-Louis Peydr6é
(2022) «Monetary policy and inequality.» Journal of Finance, 78, August, pages
2945-2989.

Ball, Laurence (1994) «What determines the sacrifice ratio?» The University of
Chicago Press, volume: Monetary policy, January, pages 155-193.

Berger, David, Konstantin Milbradt, Fabrice Tourre, and Joseph Vavra (2021)
«Mortgage prepayment and path-dependent effects of monetary policy». American
Economic Review, 111 (9), September, pages 2829-2878.

Cerutti, Eugenio, Jihad Dagher, and Giovanni Dell'Ariccia (2017) «Housing finance
and real-estate booms: A cross-country perspective». Journal of Housing
Economics, 38, December, pages 1-13.

Cloyne, James, Clodomiro Ferreira, and Paolo Surico (2020) «Monetary policy when
households have debt: new evidence on the transmission mechanism.» Review of
Economic Studies, 87 (1), January, pages 102-129.

Eichenbaum, Martin, Sergio Rebelo, and Arlene Wong (2022) «State-dependent ef-
fects of monetary policy: The refinancing channel.» American Economic Review, 112
(3), March, pages 721-761.

Fagereng, Andreas, Helene Onshuus, and Kjersti N. Torstensen (2024) «The con-
sumption expenditure response to unemployment: Evidence from Norwegian
households.» Journal of Monetary Economics, March.

Fagereng, Andreas, Martin B. Holm, and Gisle J. Natvik (2021) «MPC heterogeneity
and household balance sheets». American Economic Journal: Macroeconomics, 13
(4), October, pages 1-54.

Flodén, Martin, Matilda Kilstr6m, Josef Sigurdsson, and Roine Vestman (2020)
«Household Debt and Monetary Policy: Revealing the Cash-Flow Channel».
Economic Journal, 131 (636), May, pages 1742-1771.

Forbes, Kristin, Jongrim Ha, and M. Ayhan Kose (2024) «Rate cycles». The World
Bank Development Economics Prospects, Working Paper.

Holm, Martin Blomhoff, Pascal Paul, and Andreas Tischbirek (2021) «The transmis-
sion of monetary policy under the microscope». Journal of Political Economy,
129(19), July, pages 2861-2904.

International Monetary Fund (2024) World Economic Outlook - Steady but Slow:
Resilience amid Divergence. IMF, April 16.

McKay, Alisdair and Christian K. Wolf (2023) «Monetary policy and inequality».
Journal of Economic Perspectives, 37 (1), Winter, pages 121-144.

Romer, David (1993) «Openness and inflation: theory and evidence». The quarterly
journal of economics, 108 (4), November, pages 869-903.

McKay, Alisdair and Christian K. Wolf (2023) «Monetary policy and inequality.»
Journal of Economic Perspectives, 37 (1), pages 121-144.

Footnotes
[1] Forbes, Ha and Kose (2024).

[2] Flodén et al. (2021) and International Monetary Fund (2024) use similar
definitions.

[3] Debt net of deposits more accurately captures how much a given change in pol-
icy rates affect disposable income, at least when both lending rates and deposit
rates closely follow short-term rates. Chart 2 shows gross debt because we do not
have extensive cross-country data on deposits.

[4] This does not take into account cross-country variation in the tax system and the
particular structure of adjustable-rate and fixed-rate mortgage contracts, both of
which can affect pass-through. First, long-term mortgages (e.g. 30 years) are more
common than shorter-term (e.g. 2-5 years) in some countries than in others.
Second, in some countries, households are allowed to deduct mortgage interest
payments from taxable income. How much this deduction amounts to varies sub-
stantially across countries (Cerutti, Dagher and Dell'Ariccia, 2017). A high tax deduc-
tion reduces pass-through of the policy rate to disposable income. Third, under the
terms of annuity loans - such as the ones common in Norway -- principal payments
are automatically reduced in the short run when the lending rate increases. This
might also lower pass-through to consumption.

[5] Interest payments net of interest income for the private sector has been negative
in the US and positive in Norway for every quarter of available data, respectively
since 1947 for the US (Bureau of Economic Analysis, Personal Income and its
Disposition) and 1999 for Norway (Statistics Norway, quarterly non-financial sector
accounts).

[6] See Ahn, Galaasen and Meehlum (2024). Confidence intervals as well as esti-
mates for other horizons are included in the paper. Cloyne, Ferreira and Surico

(2020) and Flodén et al. (2020) also estimate how the effect of monetary policy
varies along this dimension.

[7] Ahn, Galaasen and Meehlum (2024) also provide estimates of the consumption re-
sponse along the dimension of (debt-deposits)/income.

[8] The estimated marginal propensity to consume out of interest expenses is
around 30 percent, which is within the range of MPC estimates out of other types of
income shocks.

[9] Obviously, the strength of monetary policy transmission to consumption will also
depend on other aspects of household balance sheets than those mentioned here.
We know, for example, that households with very low levels of liquid assets relative

to income are especially vulnerable to income losses. These so-called "hand-to-
mouth" households have a particularly high marginal propensity to consume out of
changes in disposable income, and their consumption responds more strongly to
monetary policy. Fagereng, Holm and Natvik (2021) and Fagereng, Onshuus and
Torstensen (2024) provide evidence from Norwegian microdata that the MPC out of
income shocks due to, respectively, lottery winnings and job loss is higher for
households with low liquid assets-to-income. Holm, Paul and Tischbirek (2021) find
evidence that consumption following an interest rate hike drops more for house-
holds with low liquid assets-to-income.

[10] McKay and Wolf (2023) argue for a version of this view.

[11] There is a growing research literature investigating the distributional impact of
monetary policy. See e.g. Amberg et al. (2022), Andersen et al. (2023), and McKay
and Wolf (2023).

[12] In the dataset of advanced and emerging economies shown in Chart 5, the me-
dian country - when ordering countries by the percentage increase in household
debt-to-income over the period - doubled its household sector debt-to-dispos-
able-income ratio between 1995 and 2021.

[13] This number is derived from the equation (% change in consumption due to
cash-flow effect) = MPC x (change in lending rate) x
(debt/income)/(consumption/income). We assume an MPC of 30% out of interest
payments (Ahn, Galaasen and Meehlum, 2024), close to full pass-through of policy
rates to lending rates, an average consumption/income ratio of 0.7 and an increase
in debt/income of 120 percentage points. This assumes that other parts of the
transmission mechanism, as well as the MPC, stay the same.

[14] Estimates based on Norwegian data from the mid-1990s until the early 2020s or
late 2010s indicate that the consumption response to a one percentage point mone-
tary policy shock peaks at around one percent after 1-2 years (see Norges Bank's
Monetary Policy Report 2/2022, p. 40, and 4/2023, p. 52). Assuming that the increase
in debt-to-income has increased this response by 0.5 percentage points over the
same sample period, the total response of consumption would have been around
0.75 percent in 1995.

[15] See figure 2.13 in International Monetary Fund (2014).

[16] This dimension of monetary policy pass-through is explored by Eichenbaum,
Rebelo and Wong (2022) and Berger et al. (2021).

[17] See the equation from the previous paragraph. We assume that we go froma sit-
uation with no short-run monetary policy pass-through to lending rates to a situa-
tion with full pass-through.

[18] This argument is made by Romer (1993).

[19] When the exchange rate channel is relatively more important, the sacrifice ratio
is lower (see Ball (1994) and Romer (1993)).

Published 24 August 2024 20:00