RECENT DEVELOPMENTS AFFECTING THE EFFICIENCY OF MONETARY POLICY

by PHIL GRAHAM' and GRAHAM HODGES2

1. Introduction The prime motivation for this paper is the observation over recent years

of a number of changes which could change the responsiveness of the economy to adjustments in monetary policy. At the outset it should be noted that this analysis adopts a practitioner's approach, rather than taking a more theoretical tack; in any case, it seems likely that, given the recent nature of the changes being discussed, attempts to use a more rigorous model-based approach would face many difficulties, at least at this point in time.

it starts by defining the way monetary policy impacts on an economy,

discusses recent developments which may affect the implementation of

draws some conclusions about the implications of these developments

The paper covers three broad areas:

including recent international evidence;

monetary policy in Australia; and

for current policy.

2. Defining the "kansmission Mechanism An examination of the efficiency of monetary policy first needs to look

at how monetary policy impacts on an economy. The effectiveness of monetary policy comes via the transmission mechanism to the real economy. In practice, monetary policy works through the following avenues:

firstly, it affects the cost of borrowing for new borrowers, and requires existing holders of debt to allocate additional funds to service debt, This might be termed the cash flow effect; secondly, by changing net wealth, such as if higher interest rates lead to a decline in asset markets. We can call this the wealth effect; thirdly, by influencing the real exchange rate, changes in interest rates can have an impact on domestic competitiveness, and on the level of economic activity. For example, an increase in interest rates might

1. Chief Economist, ANZ McCaughan Securities. 2. Group Chief Economist, Australia and New Zealand Banking Group Limited.

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normally be expected to cause the real exchange rate to appreciate, reducing income from overseas, and having a deflationary impact on the domestic economy; and finally, in addition to these traditional mechanisms we could add the announcement effect of changes in policy which impact on expectations of consumers and business. The efficiency of monetary policy, in the context of this paper, refers to

the speed and strength with which policy changes affect the real economy. Our discussion of recent developments will focus on this issue.

3. Recent International Evidence There has, as one would expect, been a substantial amount of research

on this issue. The Reserve Bank of Australia has had an ongoing research interest in the transmission mechanism. Internationally, there has also been much focus on the broad issue.3

Interest in the monetary policy transmission mechanism was sparked by the slower than expected response of real economic growth to monetary policy during the recent recession; the fact that different countries respond differently to monetary stimuli; and, reflecting the European exchange rate turbulence of 1992/93, how far short-term interest rates could be used to manipulate currency values without adverse effects on real economic activity.

The Bank of International Settlement (BIS) noted that as a result of financial deregulation and changes in indebtedness, the cash flow impli- cations of monetary policy have become increasingly important in recent years. They suggest the importance of the cash flow effect depends critically on three factors:

The net indebtedness of individual firms and households. But creditor and debtor behaviour may be asymmetric, and net interest payments may not be a good guide to net indebtedness. The responsiveness of customer interest rates to rates set by the central bank. The BIS suggests that as the importance of the cash flow effects probably hinge disproportionately on the behaviour of net borrowers, the degree of pass-on of central bank increases to lending rates is particu- larly relevant. The importance of the cash flow channel therefore depends on the maturity structure of borrowings and the extent to which contractual lending rates are adjustable. The ability of firms and households to increase their borrowing. The BIS concluded that “monetary policy ... is likely to have a quicker

effect on the demand for goods and services, and hence real economic activity, in countries which borrowing is largely at variable interest rates or at short-term.”

3. See for example the 1994 Annual Report of the Bank for International Settlements which reports the procedures of a 1993 BIS international conference on the trasmission mechanism.

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4. Recent Developments Affecting the Efficiency of Monetary Policy in Australia

In this light, it is convenient to discuss the impact of the recent develop- ments to monetary policy transmission in terms of the four main channels outlined above. Given the key role of the cash flow effect, and its signficance (according to the BIS), we start with that channel.

4.1 Recent Developments Impacting on the Cash Flow Effect Narrower Bank Margins are Limiting the Impact on Cash Flows

The first point to be made with respect to the cash flow effect is that under the pressure of increased competition, banks have to date passed on only about half of the increase in official cash rates onto mortgage rates. Given that one of the aims of policy is to restrict the cash flows of business and consumers and reduce spending, it is clear that the increased com- petition in banking will, at least in its early stages, frustrate the effective- ness of monetary policy. We might expect that after the initial few tighten- ings, banks will be unable to resist passing through a larger part of rate increases.

For monetary policy, this raises some important issues - the size and timing of rate increases needed to achieve the desired impact on cash flows.

Fixed Rate Lending will Further Limit the Impact of Interest Rate Changes

One of the biggest changes which has taken place in the market for lending in recent years has been the marked increase in the ability of bor- rowers to “lock-in” to fixed rate lending products. Over recent years, the array of fixed rate loan products has increased significantly, and with competitition increasing markedly, banks in particular have seized the opportunity to offer these products to their customers.

The propensity of borrowers to take up the opportunity to lock-in fixed rates has varied across the lending spectrum, but the change since the last cycle has been greatest in the housing market, where competition has been most intense. The profusion of fixed rate loan offers which have hit the market in the last few years has clearly upped the ante in the competitive- ness stakes. Over the past few years, at least half of all housing lending has been at fixed rates, with most of this focussed on the 1 year fixed rate offers (the so-called “honeymoon rate”). The remainder has remained at variable rates.

The increasing tendency for new home borrowers to take up fixed rate loans in recent years has led to a marked increase in the proportion of the stock of existing mortgages which is on a fixed interest rate. If we define a fixed rate loan as being of 1 year or more, banking system figures show that as at September 1994, over 25% of the stock of housing loans was at fixed interest rates, about double the level of two years earlier. With the shorter

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term fixed rate offers generally at lower interest rates than the variable rate loans, it seems almost certain that over time there will be a further steady increase in the proportion of home lending done at fixed rates.

For the moment, in terms of the impact on monetary policy, there are a number of issues to consider.

First, although the recent increase in official interest rates has led to an upward adjustment in the fixed rate mortgage deals on offer by the banks (as well as having been passed on to some extent to variable rate mortgage interest rates), those new borrowers at fixed rates will for a time be insulated from tighter monetary policy. Given that these borrowers are the marginal borrowers who would normally be most impacted by rate increases, this must act to diminish the near term impact of policy.

Second, this element is being exacerbated competition. Even when fixed rate offers expire it is common to "roll over" these loans into a new fixed rate offer, rather than switching the borrower to the variable rate (which is what the contract specifies). The business sector is generally more sophisticated in its knowledge and

understanding of the increased array of fixed rate or capped products available. According to the Reserve Bank, about 27% of business lending is at fixed rates. However, it should be noted that because business can make use of derivative products to alter the initial characteristics of a loan (eg, switch from fixed to floating or vice versa), it is not clear how much of the end product remains fixed.

From our point of view, it has been somewhat surprising to see only apparently limited business use of fixed rate products in recent times, par- ticularly given the historically low level of interest rates. To some extent this development owes to the prevailing view, at least until recently, that interest rates would not rise sharply, as well as to a perception that the sell- off in bond and futures markets has made the cost of locking-in relatively unattractive compared to the floating rate alternative.

International experience offers some guidance in this area. The recent BIS work shows that countries which have a larger proportion of lending at variable rates (eg, the United Kingdom) respond relatively quickly and strongly to a tightening in monetary policy. On the other hand, in countries where fixed rate lending is more prevalent (eg, France), the response appears limited and delayed.

Low Interest Rates Also Give Protection to Existing Borrowers Although interest rates are again on the increase, it needs to be recog-

nised that this is from a very low level by recent Australian standards. One of the noticeable factors during the downswing in interest rates has been the number of borrowers who, in the face of declining mortgage interest rates, chose to hold repayments at the same dollar amount, effectively pay- ing off their loans over a shorter time period.

With interest rates rising, these same borrowers have a reasonably large

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degree of leeway before higher mortgage rates actually impact on their cash flow. Moreover, even when interest rates reach a level warranting increased repayment, borrowers will still have the option of increasing the term of the loan, thus potentially providing even further leeway.

Apart from the increase in price competition we have discussed above, another area of potential competition is in the term and conditions of a loan. For example, allowing customers to move to interest only or extend- ing the term of the loan should they face difficulties, as well as removing payment acceleration clauses, are emerging as new issues.

But Household Debt Has Increased in the 1990s Offset against these aspects is the rapid growth in housing lending and

more recently other personal lending, which has lifted the household sector's gearing level. Chart 1 below illustrates the extent of the increase. The ratio of household debt to income began in the 1980s at around 40% and jumped to 50% over a short period in the mid-1980s before plateau- ing. However, the strong increase in home lending in the 1990s has seen the ratio climb to 6396, and is expected to rise further to 70% before stabilising at the new high.

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Although lower interest rates over recent years have reduced the house- hold debt service burden, the cycle is now moving against the household sector. Even though interest rates are expected to rise more modestly in this cycle, debt servicing will return to the peak levels reached at the height of interest rates in the late 1980s. As discussed above, fixed rate mortgages will cushion the impact of higher interest rates, but given the dominance of short term fixed rate mortgages, the buffer will only be tem- porary. As variable and fixed rate loans are pre-priced, householders will begin to be squeezed financially. Chart 2 illustrates the extent of the expected increase in debt servicing.

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CHART 2

DEBT SERVICING & INTEREST RATES U

Though Corporate Gearing is Lower On the other hand, another difference between the 1980s and the 1990s

has been the rapid change in the structure of corporate balance sheets. While the high interest rate policy of the late 1980s provided a fertile field on which monetary policy could work, during the subsequent five or so years the business sector has acted aggressively to get their balance sheets back into shape, and debt outstanding has been reduced by a significant amount. Gearing is now back to the level it was in the late 1970s.

Chart 3 illustrates that overall corporate gearing has fallen from over 80% to less than 40% now. Excluding some large debt companies, the fall in gearing is less marked, but still large, from 50% to 30%.

CHART 3

AUSTRALIAN COMF'i'Z GEARING LEVELS N.1 E-. %

m

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Chart 4 confirms the decline in business debt outstanding, and shows recent business funding trends. After the sharp increase in funding in the late 1980% total funding needs dived sharply in the recession of the early 1990s. The increase in business funding via debt declined from 1988, and continued through to early 1993. From end 1990 to end 1993 total business debt contracted. Although total funding needs again increased after 1991, this funding was met entirely by internal sources of funds up until 1993, when equity raisings increased. Only in 1994 has debt re-emerged as a third source of business funding.

CHART 4

There is one important distinction to be drawn in this area, however- the difference in restructuring between the large and smaII business sec- tors. As a general rule, big businesses have done more to reduce debt than middle and smaller sized businesses. Based on ANZ estimates, gearing at the small business level is about 40% higher than for big business. This clearly suggests that when monetary policy does not bite, it will have a more significant impact on the small business sector.

From the point of view of the effectiveness of monetary policy, lower levels of business gearing and strong profits growth will tend to delay the business sector's response to higher interest rates.

4.2 Recent Developments Impacting on the Wealth Eflect Markets are More Forward Looking than in the Past

A further consideration to take into account is that markets are becom- ing increasingly forward looking as time goes on. Increasingly sophisticat- ed markets, with a wider array of products available, backed by the power of vasts amounts of capital, seems to be making markets increasingly for- ward looking (some may say paranoid). In a sense, it may be argued that this observation has already been proven by the events seen in the bond market this year, where it has been difficult to justify the sharp and sub-

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stantial weakening in the bond market based on current forecasts of in- flation. Instead, markets appear to have taken a pessimistic view of the likely outlook over the next few years, and telescoped that view forward into current bond yields. Only time will tell whether markets have been forward looking or blinkered.

The sharp weakening in bond markets, while short-term markets have not increased to the same extent, has led to sharp steepening in the yield curve. Although it is traditionally argued that positive yield curves indicate stimulatory policy settings, it seems unlikely that current policy settings are as stimulatory as would normally be implied by the current shape of the yield curve. Indeed, it can be argued that the increase in bond yields may in fact be contradictory, as fixed interest rates (swap rates) have increased substantially, potentially increasing the cost of finance on projects financed through these means.

The more forward looking approach adopted by markets could well act to increase the effectiveness of monetary policy relative to that in the 1980s.

4.3 Recent Developments Impacting on the Announcement Effect Changes in the Implementation of Monetary Policy

lhrning to changes to monetary policy itself, one of the most obvious developments in the implementation of monetary policy in the 1990s has been the Reserve Bank‘s approach of publicly announcing monetary policy changes.

Quite clearly, the aim of this altered approach is to have a much more significant “announcement effect” on the economy than was the case with the previous method, leading to a more efficient transmission mechanism to the real economy. In particular, the previous upswing in interest rates in the period 1988-89 was marked in its early stage by an apparent reluctance of the authorities to admit they were tightening policy. This period of cloak and dagger policy making, euphemistically known as “snugging”, is thought to be at least partly the reason that the economy ultimately ran out of control in 1989/90.

But how effective is the new policy approach likely to be? There are arguments on both sides in this debate. While there will definitely be a much clearer understanding of the intentions of policy makers, a situation made even more apparent by the relatively aggressive increases put in place to date, there are also other factors which are acting to diminish the “announcement effect”.

The most important of these is the tendency of politicians to downplay the importance of the rate increases we have seen, with regular comments being made that because inflation is being maintained at much lower levels than in the 198Os, interest rates will not rise to the same extent as in that period. These comments are having the effect of downplaying the impact of the initial announcement effect.

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5. Implications for Monetary Policy Assessment of the overall impact of the forces discussed above is

clouded by their offsetting nature. However, given the importance attached to the cash flow effect, it is our assessment that the net effect of the move by banks to absorb some of the increase in official interest rates, the cumu- lative effect of the move towards fixed rate lending, and the lower level of business gearing relative to the 1980s will be acting to limit the efficiency of monetary policy transmission, particularly in the early stages of the tightening process.

In terms of the medium term impact of policy, however, it seems likely that the cumulative effect of monetary policy tightening will continue to be effective, as the announcement, wealth and exchange rate effects com- bine with a delayed cash flow effect to influence the level of economic activity.

Nevertheless, this timing difference is the impact of policy is potentially important in two ways.

First, because the economy may be given more time to gather steam, eventually requiring more tightening to slow spending as required. Second, with policy apparently not impacting in its initial stages, the authori- ties may be tempted to put in place more tightening, with a greater risk of overkill. When the tightening bites, it is likely to have a disproportionate effect on the small business sector.

Although it is still early days in the tightening process, an assessment of the current stance can be gained by examining the impact of the tighten- ing in monetary policy to date on the channels we have been discussing.

The Cash Flow Effect. Looking at the impact of recent increases in official cash rates on spending power (such as via mortgage payments), there appears to have been little impact to date. Even though household debt has increased, the lack of flow through of official tightenings, plus the other factors noted earlier, is clearly frustrating policy effectiveness at the present time. Evidence from the various business surveys also suggests little impact from the interest rate increases to date. Consumer confidence did decline for a few months after the first rate increases, but has since bounced back, and overall remams at a high level. While house lending has begun to slow, it is more for underlying demand reasons than because of deteriorating affordability. In the housing market, however, it has been noticeable that the level of refinancing has dropped back sig- nificantly with the increase in rates, as existing borrowers appear to have decided against switching loans. The Wealth Effect. Asset markets (mostly shares and bonds) have soft- ened during 1994. The bond market collapse will be having some impact on the investment community (particularly retirees), while Australian share prices have fallen 20% since the beginning of the year.

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Both these aspects will have a deflationary impact, but it is difficult to judge how potent this challenge is. The Real Exchange Rate Effect will also be deflationary, with the Australian dollar having risen by 16% in trade weighted terms since the low point in September 1993. The Announcement Effect. Given that this is the first period in which clear official announcements about monetary policy have been made and the offsetting arguments, it is difficult to make an assessment about the effectiveness of this transmission channel.

While there is evidence of deflationary forces in a number of the monetary policy transmission channels, there is as yet little to suggest any impact on the key channel-the cash flow effect.

6. Conclusion This paper examines recent developments which are likely to have an

impact on the efficiency of monetary policy. By breaking the channels of monetary policy transmission into their key components, we find that while the efficiency of some channels-the wealth, exchange rate and announcement effects-remain intact (and may have been strengthened), the efficiency of the key channel of transmission-the cash flow effect-is likely to have been reduced.

Given the importance of the cash flow effect, this has potentially signifi- cant implications for the conduct of monetary policy. In particular, it sug- gests that, in order to achieve its desired impact, monetary policy may need to be tightened more quickly and by a larger amount than would otherwise have been required.

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