Cash flows and the effectiveness of monetary policy

Higher interest rates have the same estimated effect on inflation in Australia, the euro area, and the USA.
Kieran Davies

Coolabah Capital

Despite the greater importance of household cash flows locally, the estimated effect of higher interest rates on inflation is the same in Australia as most other countries.  Inflation is not very sensitive to higher interest rates, which suggests that central banks think recent high inflation mostly reflects temporary supply factors.  

Many analysts have pointed out that mortgage rates have increased by more to date in Australia than in other advanced economies, even though the RBA has raised the policy rate by less than nearly all of its peers.  

The RBA has hiked by less than most other
countries, but, to date, Australia’s mortgage rate has increased by more than
its peers
The RBA has hiked by less than most other countries, but, to date, Australia’s mortgage rate has increased by more than its peers

However, the resulting squeeze on household cash flows is not new news as it reflects the combined effect of higher household indebtedness and greater use of variable-rate mortgages in Australia, such that the debt servicing ratio of Australian households is higher and more variable compared with other advanced economies.

The debt servicing ratio for Australian households is
higher and more variable than most other countries
The debt servicing ratio for Australian households is higher and more variable than most other countries

For example, the US household debt servicing ratio is much smoother in comparison and is yet to react much to recent Fed rate rises given most existing borrowers have locked in much lower long-term mortgage rates.

The US household debt servicing ratio is relatively smooth because most borrowers have locked in low mortgage rates
The US household debt servicing ratio is relatively smooth because most borrowers have locked in low mortgage rates

The story for the cash flow of non-financial corporations is similar in that the corporate debt servicing ratio is generally higher and more variable in Australia than in most other advanced economies, although the difference is less marked than for the household debt servicing ratio and the local corporate debt servicing ratio hasn't picked up yet given the importance of cashed-up mining companies.  

The debt servicing ratio for Australian businesses is also
higher and more variable than most other countries
The debt servicing ratio for Australian businesses is also higher and more variable than most other countries

The greater importance of the household cash flow channel of monetary policy in Australia has led many analysts to believe that higher interest rates are more effective in Australia than in other countries. 

However, this does not appear to be the case, in that central bank estimates of the peak effect of higher interest rates on the ultimate objective of inflation – calculated using both macroeconometric and DSGE models – is the same in Australia, the euro area and the US.

This suggests that the combined effect of all the different channels of monetary policy – i.e., household and corporate cash flows, the exchange rate, asset prices, expectations, etc – on inflation is both similar between Australia and other countries and fairly small.  

Despite the greater importance of household cash flows
locally, higher interest rates have the same estimated peak effect on inflation
in Australia as most other countries
Despite the greater importance of household cash flows locally, higher interest rates have the same estimated peak effect on inflation in Australia as most other countries

Using the central bank model estimates of the peak effect of higher policy rates on inflation, Australia has hiked by less than both the ECB and the Fed, such the RBA’s likely role in bringing inflation down is much less than what a narrow focus on the household cash flow channel would suggest.

Unless inflation has suddenly become more responsive to higher interest rates, the estimates also indicate that central banks are implicitly assuming that most of the recent surge in inflation reflects temporary supply factors that are now being unwound, with much less of a role for the demand-driven inflation that is sensitive to high interest rates. 

Central banks implicitly assume that most of the
reduction in inflation will reflect the unwinding of temporary supply shocks rather
than demand-driven price increases that are sensitive to interest rates
Central banks implicitly assume that most of the reduction in inflation will reflect the unwinding of temporary supply shocks rather than demand-driven price increases that are sensitive to interest rates
........
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Kieran Davies
Chief Macro Strategist
Coolabah Capital

Based in Sydney, Kieran Davies is Chief Macro Strategist at Coolabah Capital Investments, an asset manager with 40 executives and over $8 billion in fixed-income strategies. Kieran is responsible for macroeconomic research and investment strategy,...

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