RDP 2016-12: The Household Cash Flow Channel of Monetary Policy 7. Conclusion

We find evidence for the existence of a ‘borrower’ cash flow channel. In accordance with intuition, it appears to work mainly through households with variable-rate mortgage debt, and there is evidence that the effect of interest-sensitive cash flows on spending is particularly strong for liquidity-constrained households. We find some evidence for the existence of a lender cash flow channel, but the estimated effect is not strong enough to offset the borrower cash flow channel at an aggregate level. Importantly, changes in monetary policy have distributional effects that do not ‘wash out’ in the aggregate because of differences between borrowers and lenders in propensities to consume and in average holdings of net interest-earning assets. Borrowers have a higher propensity to consume than lenders, and borrowers have more net debt than lenders have net interest-earning liquid assets, on average. This implies that lower interest rates increase household cash flows, and spending in aggregate, via the cash flow channel.

The central estimates indicate that a 100 basis point cut in interest rates is associated with a 0.1 to 0.2 per cent increase in household spending in aggregate. This is within the range of estimates produced by macroeconomic models that examine how changes in the cash rate affect household consumption in Australia.

We also find some evidence that mortgage borrowers have used some of the cash flows generated by lower interest rates to prepay their mortgages rather than spend. This process can reduce the expected life of household debt and hence bring forward the day when households feel comfortable about increasing their consumption. Overall, our results suggest that the cash flow channel is an important channel of monetary policy transmission to household spending in Australia.