MNI ANALYSIS: Household Debt Makes RBA Cut Null, Or Worrisome

--But Household Cash Flow Could Still Make Case For RBA Cut

By Sophia Rodrigues

     SYDNEY (MNI) - The Reserve Bank of Australia considers any further cut in

the cash rate will be either ineffective or worrisome, depending on whether or

not households take on more debt in response to lower rates, but this doesn't

preclude scenarios where a rate cut might be considered.

     This thinking references the household cash flow channel of monetary

policy, where the borrower channel is estimated to be the stronger domestic

channel of monetary transmission. 

     If developments outside the RBA's control force mortgage rates higher, the

RBA may be prepared to lower the cash rate if it believes borrowing households

are likely to reduce consumption in response to higher rates. 

     The importance of the household cash flow channel also means the RBA is

unlikely to raise the cash rate unless it is certain households have sufficient

income to cope with higher mortgage rates without hurting overall spending

behaviour.

     --MORE CUT INEFFECTIVE OR WORRISOME

     At the July board meeting, the RBA had a detailed discussion on the high

level of household debt in Australia, based on a special paper prepared for the

meeting. In the minutes, the RBA revealed the key points of the discussion but

in the weeks ahead it might either publish the full paper, or use the contents

in a speech by a senior official or as a special topic in the August Statement

on Monetary Policy.

     The paper said what the RBA has said repeatedly in the past few years --

that households with high debt levels are more vulnerable to economic shocks and

therefore more likely to reduce consumption in the face of uncertainty about

their future income.

     The paper also noted that changes in interest rates have a larger effect on

disposable income for households with high debt levels, but made an important

observation that such households may be less inclined to borrow more at times

when interest rates fall.

     Given one of the aims of easing monetary policy is to encourage more

borrowing in the economy, the RBA thinks a lower cash rate will be ineffective

if it doesn't spur additional borrowing.

     But should it actually lead to households taking on more debt, that would

be a worrying trend too. It is this worry that has prevented Governor Philip

Lowe for lowering the cash rate further and instead he has been showing greater

tolerance for low inflation.

     In effect this means there would be no justification for lowering the cash

rate any further.

     --CASH FLOW CHANNEL STILL IMPORTANT

     However, the paper hasn't delved into another important manner in which

monetary policy affects households and thus the economy. 

     This is the household cash flow channel, where changes in interest rates

affect the amount of cash that households have available to spend. This channel

assumes more significance if a lower cash rate is indeed likely to be

ineffective as it won't lead to additional debt.

     A research article published by the RBA in 2016 and still relevant, found

that the borrower channel is the stronger channel of monetary transmission,

concluding that lowering the cash rate by 100 basis points is associated with an

increase in aggregate household income of around 0.9%, which would, in turn,

increase household expenditure by about 0.1%-0.2% through the cash flow channel.

     Now, more than ever, the household cash flow channel will be an important

determinant for monetary policy because wage growth remains sluggish and any

rise in interest rates might disproportionately affect household spending.

     That is why even as Governor Lowe has signalled the next move in the cash

rate is more likely to be higher, he has reminded that the environment in which

interest rates are increasing is likely to be the one in which people's incomes

are growing more quickly than now.

     But if interest rates rise before income growth accelerates, and that could

happen if banks make significant increases in mortgage rates, then an RBA

reaction will depend on their estimate of how much it might affect household

spending, and whether it is significant enough to hurt growth prospects for the

economy.

--MNI Sydney Bureau; tel: +61 2-9716-5467; email: sophia.rodrigues@marketnews.com

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