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.
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.
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.
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 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 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.
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.
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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, contributing to the investment decisions of the firm. Kieran has long experience as a macroeconomist in both the private and public sectors. He has worked most recently as Chief Markets Economist for National Australia Bank and was previously Chief Economist, Australia and New Zealand, for Barclays Bank and ABN Amro Bank/RBS. Kieran also worked as Principal Adviser on the macroeconomy and budget policy in the Commonwealth Treasury and Director of Forecasting.
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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,...
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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