Christopher Kent, Assistant Governor (Economic), gave a speech in Canberra at the Australian National University entitled “Monetary Policy Transmission – What’s Known and What’s Changed“. In the speech he dissects the way in which changes to monetary policy flows on through the economy to households and firms. Its a relevant discussion because the recent monetary easing has not so far translated into the desired outcomes in the current cycle. We think he is correct to assert that segmented analysis of households needs to be incorporated into the thinking, as based on our surveys we see that different household groups, are behaving in very different ways.
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.
- The Reserve Bank lowers the overnight cash rate.
- Financial markets update expectations about the future path of cash rates and the structure of deposit and lending rates are quickly altered.
- 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).
- 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.
He concludes that 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 household-level data. To use a botanical analogy, to know more about a plant, it’s helpful to observe how its different types of cells work.