RDP 2016-12: The Household Cash Flow Channel of Monetary Policy 1. Introduction

Changes in monetary policy directly affect the household sector through several channels. Lower interest rates can encourage households to save less and bring forward consumption from the future to the present (the intertemporal substitution channel). Lower interest rates can also lift asset prices, such as housing prices, and the resulting increase in household wealth may encourage households to spend more (the wealth channel). Additionally, lower interest rates reduce the interest payments of borrowing households with variable-rate debt, resulting in higher cash flows and potentially more spending, particularly for households that are constrained by the amount of cash they have available (the borrower cash flow channel). At the same time, lower interest rates can reduce the interest earnings of lending households, which may in turn lead to lower cash flows and less spending for these households (the lender cash flow channel). These last two channels together will be referred to as ‘the household cash flow channel’ in this paper.

This paper explores whether a household cash flow channel of monetary policy exists in Australia. The analysis focuses on a fairly narrow definition of the cash flow channel. It examines the direct effects of interest rates on interest income and expenses, but abstracts from monetary policy changes that have an indirect cash flow effect by influencing other sources of income, such as labour or business income. Auclert (2016) provides a theoretical framework for considering the indirect cash flow effects of interest rate changes.

Two important concepts that will be used throughout the paper are ‘interest-earning liquid assets’ and ‘variable-rate debt’. Interest-earning liquid assets are defined as assets that have income streams that are directly tied to interest rates and which are easily convertible to cash. For households, this is mainly savings deposits. Variable-rate (or floating-rate) debt is debt that has a repayment stream that is directly linked to interest rates with these repayments effectively repricing with the cash rate. This is mainly variable-rate home mortgage debt. Using this classification, a net borrower (lender) is a household that holds more (less) variable-rate debt than interest-earning liquid assets. The income flows that are associated with both interest-earning liquid assets and variable-rate debt will be referred to as ‘interest-sensitive cash flows’.

Broadly speaking, the household cash flow channel consists of three stages. First, changes in the cash rate are transmitted to changes in the lending and deposit rates faced by households. Second, changes in household lending and deposit rates flow through to changes in household cash flows by changing the required repayments of borrowing households and the net interest earnings of lending households. Third, changes in cash flows can affect household spending, particularly for households that are constrained by the amount of available cash (‘liquidity constrained’). This paper focuses on the latter two stages; other recent publications discuss how changes in the cash rate are transmitted to the interest rates faced by households (e.g. Wilkins, Gardner and Chapman 2016).

The cash flow channel has been described in journal articles (e.g. Mishkin 1996), speeches (e.g. Kent 2015) and public commentary (e.g. Janda 2015; Mulligan 2015; Rolfe 2015). Despite its intuitive appeal, to date there has been little formal research into the existence of the household cash flow channel, either in Australia or overseas. We make four main contributions to this new literature.

First, our identification strategy deals with the difficult practical problem of separating the cash flow channel from the other monetary transmission channels, such as the intertemporal substitution and wealth channels. To isolate the cash flow channel for borrowers we adopt a quasi-experimental research design based on the sharp decline in interest rates at the onset of the global financial crisis. Specifically, we exploit the fact that short-term interest rate changes should have a more immediate (and larger) effect on the cash flows of households with variable-rate debt than on the cash flows for comparable households with fixed-rate debt. In effect, if the cash flow channel exists, a cut in interest rates should lead to lower interest repayments and a corresponding increase in cash flows and spending for variable-rate borrowers, relative to fixed-rate borrowers.

Cloyne, Ferreira and Surico (2015) take a similar approach in comparing the responses of mortgagor households in the United Kingdom and the United States following a monetary policy shock. Their identification strategy relies on the fact that most UK mortgages are at variable rates, while most US mortgages are at fixed rates. They argue that the consumption and cash flow response of mortgagor households should be stronger in the United Kingdom than the United States if there is a cash flow channel. However, differences in macroeconomic conditions between the United States and United Kingdom could drive any observed differences in the correlation between household cash flows and expenditure across the two countries. By exploiting variation between fixed-rate and variable-rate households within the same mortgage market, we are able to better control for unobserved characteristics that might drive a differential response to interest rate shocks for reasons other than the cash flow channel.^[1]

Flodén et al (2016) study the cash flow channel in Sweden using administrative data. They show that interest rate shocks affect the cash flows of households with variable-rate mortgage debt and that this, in turn, has a strong effect on their spending. They find a marginal propensity to consume out of cash flows that is equal to (or greater than) unity. Despite having a very rich dataset, they do not exploit the differential responses of variable-rate and fixed-rate borrowers to interest rate changes. Arguably, the results are potentially driven by the other channels of monetary policy.

Second, we explore the quantitative importance of both the borrower and lender channels. There are a handful of studies that examine the borrower cash flow channel. For instance, Di Maggio, Kermani and Ramcharan (2014) and Keys et al (2014) exploit differences across mortgagor households in the timing of mortgage rate resets to identify the effect of anticipated interest rate changes on household spending and debt repayment in the United States. They find that households spend some of the extra income after a cut in mortgage rates (but also pay down more debt). This is evidence in favour of a borrower cash flow channel.

In contrast, there is virtually no research on the lender cash flow channel.^[2] Previous research may provide a poor guide to the importance of the aggregate cash flow channel to the extent that the lender channel is ignored. For instance, if there are more lenders than borrowers in the economy and/or lenders have a higher propensity to consume out of cash flows than borrowers, then lower interest rates may have a negative effect on household cash flows overall and lead to less spending in aggregate.^[3]

Third, we highlight the role of mortgage prepayment behaviour in affecting the sensitivity of the economy to changes in monetary policy via the cash flow channel. Australia has a relatively high share of borrowers with variable-rate mortgage debt by international standards (at around 80 per cent of all mortgages). This suggests that it should be an important channel of monetary transmission (and may explain why it receives so much media attention).

However, there are institutional features of the Australian mortgage market that complicate the links between interest rates, mortgage repayments and cash flows. In Australia, variable-rate mortgage borrowers can prepay their mortgages without penalty. So when mortgage lending rates fall, some variable-rate mortgage borrowers may choose to maintain their existing level of repayments rather than make the lower required mortgage repayments. For these households, the cash flows available for spending on goods and services are unchanged despite lower interest rates. In effect, any interest rate-induced change in cash flows is absorbed by changes in saving in the form of excess repayments (the difference between what they are required to pay and actually pay). The ability of households to ‘smooth’ their cash flows in the face of interest rate fluctuations by adjusting excess repayments may reduce the potency of the cash flow channel of monetary policy.

This paper contributes to the literature that highlights the importance of the mortgage market for monetary policy. According to standard New Keynesian models, central banks can affect the real economy by changing nominal interest rates because prices are sticky in the short run (e.g. Woodford 2003; Galí 2008). But a recent strand of the literature has shown that changes in nominal interest rates can have real effects even when prices are not sticky because of the presence of nominal debt contracts in the economy (e.g. Doepke and Schneider 2006; Sheedy 2014; Garriga, Kydland and Šustek 2015; Sterk and Tenreyro 2016). Mortgage debt contracts specify cash flows between borrowers and lenders in nominal terms. To the extent that monetary policy affects inflation, it will affect the real value of these payments and, under incomplete asset markets, the disposable income of borrowers and lenders (Garriga, Kydland and Šustek 2016). This, in turn, will have aggregate effects to the extent that the marginal propensity to consume (MPC) out of disposable income differs for borrowers and lenders (Auclert 2016). We provide direct evidence for this in the context of Australia.

Along similar lines, this paper contributes to a new and growing literature on the distributional effects of monetary policy (e.g. Coibion et al 2012; Doepke, Schneider and Selezneva 2015; Auclert 2016; Broer et al 2016). The cash flow channel is a key channel through which changes in interest rates affect the income flows associated with assets and debt. To the extent that interest-earning assets and debt are not distributed equally across households, changes in monetary policy can directly affect the income distribution, at least in the short term, through this channel.

Finally, we also contribute to the existing literature by providing new estimates of liquidity-constrained households and assessing how the existence of such households affects the potency of monetary policy. A vast array of studies have examined how liquidity constraints affect the sensitivity of the economy to fiscal policy changes. By comparison, there has been very little research into the importance of liquidity constraints in affecting how the economy responds to monetary policy shocks.^[4]

Kaplan, Violante and Weidner (2014) introduce a theoretical framework in which the consumption of some households may be very sensitive to shocks to current income despite relatively high levels of net wealth. The key insight is that some households hold wealth in the form of illiquid assets, such as housing, and still act as if they are constrained because their liquid asset holdings are low. As such, these households may adjust their spending even in response to transitory (and predictable) income changes. We apply this framework to the Australian data and examine whether the spending of households that are estimated to be liquidity constrained (or ‘hand-to-mouth’) is more sensitive to cash flows than other households.

To preview our key results – we find that:

• The expenditure of variable-rate mortgage borrowers is more responsive than that of fixed-rate borrowers to changes in interest-sensitive cash flows. This evidence suggests that some of the effect of interest rates on spending is due to a cash flow channel rather than an alternative channel of monetary transmission.
• We find evidence for both the borrower and lender channels but the borrower cash flow channel is a stronger channel of monetary transmission. This is because:
  • borrowers hold two to three times as much net debt as lenders hold in net interest-earning liquid assets, implying that the cash flow of borrowers is more sensitive to interest rates
  • the spending of borrowers is at least twice as sensitive as that of lenders to a given change in interest-sensitive cash flows.
• The household cash flow channel is reasonably strong at an aggregate level, with a 100 basis point reduction in interest rates being associated with a 0.1 to 0.2 per cent increase in household spending. This is within the range of estimates produced by a number of macroeconomic models that assess the effect of an exogenous change in the cash rate on household consumption in Australia, including through other channels and second-round effects.^[5]

Footnotes

Wong (2015) finds that young borrowers in the United States are more responsive to monetary policy shocks than older households, and that this consumption response is driven by home owners who refinance or take on new loans when interest rates fall. [1]

For the United Kingdom, there is some survey-based research indicating that lenders are much less sensitive to changes in interest rates than borrowers (Anderson et al 2014). For Australia, previous research has shown that the marginal propensity to consume out of interest-earning assets is small or zero (Connolly, Fleming and Jääskelä 2012). However, this estimate is better attributed to the wealth channel than the cash flow channel per se. [2]

Our research is also related to a branch of the literature that examines the correlation between consumption and the stock of debt (or leverage). These studies are typically motivated by the observation that, following the global financial crisis, many households ‘deleveraged’ by increasing their saving and repairing their balance sheets rather than spending. These studies typically find that the households that were most indebted prior to the crisis were those that reduced consumption the most during the crisis (e.g. Mian and Sufi 2010; Dynan 2012; Andersen, Duus and Jensen 2014; Bunn and Rostom 2014). While we take a different approach, we find little evidence to suggest that leverage matters directly to household spending in Australia once we control for other factors. [3]

More generally, we contribute to the literature documenting the significant heterogeneity in the sensitivity of household consumption to income shocks. Several studies have shown that the consumption response to income varies depending on the type of household and the type of income. For example, Jappelli and Pistaferri (2014) document significant heterogeneity in MPCs amongst Italian households, based on households' stated intention to spend unexpected bonuses. Estimated MPCs tended to be negatively correlated with cash-on-hand and credit constraints, and positively correlated with unemployment and retirement. Misra and Surico (2014) find that almost half of American households did not have a consumption response significantly different to zero following tax rebates intended to stimulate the economy, while a smaller number (generally low-income households) responded quite strongly. In a related area, Mian, Rao and Sufi (2013) and Mian and Sufi (2014) chronicle heterogeneity in marginal propensities to borrow and spend out of housing wealth across the income distribution. [4]

For example, see Lawson and Rees (2008), Jääskelä and Nimark (2011) and Rees, Smith and Hall (2016). [5]