ASIA-LINK PROGRAMME
Euro-Philippines Network in Banking & Finance
Enhancing Teaching and Research
Asialink/ASIE/B7-3010/2005/105-139
RESEARCH CONFERENCE ON
SAFETY AND EFFICIENCY OF THE FINANCIAL
SYSTEM, 27th AUGUST 2007.
This conference was organized with the support of the
EU Asia-Link Programme
Asialink/ASIE/B7-3010/2005/105-139 coordinated by
the University of Limoges (France)
ASYMMETRIC EFFECTS OF INTEREST RATE CHANGES:
THE ROLE OF THE CONSUMPTION-WEALTH CHANNEL*
Andy Mullineux
Professor of Global Finance
(University of Birmingham)
Garry McDonald
Associate Professor
(Curtin Business School)
Rudra Sensarma
Maxwell Fry Research Fellow
(University of Birmingham)
*This paper was prepared for the ASIA-LINK human resource development project:
Euro Philippines on Banking and Finance, Safety And Soundness of the Financial
System (Asialink/ASIE/B7-3010/2005/105-139)
1
1. Introduction
• The paper focuses on the wealth channel of monetary (interest rate)
policy.
• The impact of changes in interest rates on consumption via their
effects on asset prices and wealth is investigated.
• Additional influences through other channels, particularly with regard
to investment and the ‘credit channel’ are ignored, but are all clearly
not mutually exclusive.
• The paper is motivated by:
- recent interest in the effect of fluctuations in asset (house and
stock market) prices on wealth and consumption;
- increased access to credit and (house) equity withdrawal by
consumers (as a result of ‘financial innovation’).
2
• The core hypothesis to be tested is that increases in wealth (driven
by asset price increases, particularly in housing), caused by interest
rate reductions, generate increases in consumption.
• But there is an asymmetry in that falls in asset prices results in less
than proportionate falls in consumption.
• This is turn has implications for the conduct of monetary policy.
3
2. The Consumption – Wealth Channel
• (Private Sector) consumption is the largest component of aggregate
demand (much larger than investment, with public sector
expenditure in between).
• Wealth effects on consumption have long been postulated
(Modigliani et al – Life cycle hypothesis)
- we are however postulating shorter term (possibly ‘transitory’)
influences, potentially conflicting with Friedman’s related Permanent
Income Hypothesis
• As household wealth accumulates, it is affected by seemingly
increasing asset prices swings.
4
• ‘Low’ interest rates (‘cheap money’) seems to drive asset price
inflations and bubbles.
• Capital gains (e.g. in housing market) can be converted to spending
power by equity withdrawal (re-mortgaging).
– alternatively, rising asset values increase the value of collateral,
making borrowing easier and cheaper.
– lower interest (and hence discount) rates will also boost market
values of expected future income streams, reducing the need to
save.
5
3. Asymmetry
• Will rises (‘hikes’) and cuts in interest rates have a
symmetric effect?
• The behavioural finance literature (Kahneman & Tversky,
1979), finds that individuals loath losses more than they like
gains.
• Hence the losses implicit in asset price falls may not be
recognised (in the hope that will be quickly reversed) and
consumers may attempt to maintain the consumption levels
to which they have become accustomed.
– they may take on extra debt to achieve this if needs be,
and greater availability of consumer credit in the last
couple of decades has facilitated this;
– or they may run down savings.
6
•
Hence consumers try to ‘smooth’ consumption by increasing (‘net’) debt to
avoid reducing consumption.
– this may be more sustainable in the short term than the medium term;
– the sustainability of the debt levels may turn out to be dependent on how
rapidly rates are raised and how large the cumulative rise is (these are
matters for further investigation).
•
If, however, consumers do manage to avoid reducing consumption
proportionately in the face of (cumulative) interest rate hikes, then we have a
rationalisation for the ‘Ratchet Effect’ uncovered by Duesenberry (1949)
– note that Duesenberry focused on income fluctuations, whilst we focus
on wealth effects.
7
4.
Hypotheses and Data
•
The aim is to test the hypotheses:
–
that the consumption – wealth channel exists, and
–
that it operates asymmetrically.
•
The UK is initially chosen for analysis given the importance of
housing (and equities) in wealth and that it has experienced
fluctuations in house prices potentially related to fluctuations in
interest rates.
–
further, its highly developed mortgage (home loan) market
permits housing equity withdrawal (re-mortgaging) and consumer
credit markets are also well developed.
–
We hope to extend the analysis to cover the US and Australia,
whose markets have similar characteristics.
•
Other countries may increasingly experience similar asymmetric
wealth-consumption effects as financial innovation progresses in
their home loan and consumer credit markets.
8
• Data are quarterly, from 1991:Q1 to 2006:Q2.
20
15
10
5
Interest Rate
Consumption Growth
Wealth Growth
0
-5
-10
2005Q1
2003Q3
2002Q1
2000Q3
1999Q1
1997Q3
1996Q1
1994Q3
1993Q1
1991Q3
-20
1990Q1
-15
•The data reveals some interesting features:
―during the first few years, interest rate declined and was accompanied
by a rise in wealth and consumption.
―after1994 there was a period of stability before the same phenomenon
was repeated several times.
―note that interest rate hikes, as observed during 1996 to 1998 and again
during 1999 to 2000, were not accompanied by a fall in consumption.
9
5.
The Model and its Estimation
•
The model employed follows Ludvigson et al (2002), who found
only a weak role for the wealth channel in transmitting US
monetary policy, and Siokis (2005), who found that the wealth
channel did not play a strong role in transmitting interest rate
changes in the Euro area.
•
Both papers employed structural vector autoregression (SVAR)
methodology that requires the imposition of restrictions in a VAR
model.
•
To test whether interest rates have asymmetric effects and
whether the asymmetry can be attributed to the consumptionwealth channel, the following procedure is used.
•
Estimate a five-variable SVAR with consumption, income, wealth,
interest rate, inflation
10
• Identifying restrictions are based on the relevant assumptions
(Ludvigson et al, 2002) derived from the literature:
– interest rate responds contemporaneously to consumption and
income, but not the other way round (this follows Bernanke and
Blinder, 1992)
– consumption is contemporaneously affected by wealth, but the
opposite is not true (lagged consumption in the wealth equation
already summarize expectations of consumption thus not leaving
any role for current consumption)
– the interest rate does not contemporaneously respond to
changes in wealth (assuming that the central bank does not
target asset values directly but only responds to the extent that
they signal important movements in real variables or prices)
11
6.
Empirical Results: Consumption-Wealth Channel
•
We compute the impulse responses of each variable to a shock in
other variables in the estimated SVAR model.
We observe that consumption reacts positively to interest rate
shocks and the responses are statistically significant.
While this result provides prima-facie evidence of the strength of
the consumption-wealth channel we conduct a counterfactual
experiment of shutting down the wealth channel (re-estimating the
model by imposing non-responsiveness of consumption to
wealth).
Comparison of the counterfactual and the baseline scenarios
shows that the interest rate shocks have a muted impact on
consumption when the wealth channel is excluded.
The difference in the two impulse responses (significant here
unlike in Ludvigson et al) can be attributed to the presence of a
consumption-wealth channel in the UK.
The forecast error variance decomposition of the consumption
series shows that around 14% of its variation is explained by the
wealth series, as compared to interest rate changes which explain
only 6%
•
•
•
•
•
12
Impulse responses, five-variable SVAR
Response of Inflation
to Inflation shock
0 .6
0 .5
0 .4
Response of Income
to Inflation shock
0 .4
0 .04
0 .3
0 .02
0 .2
0
0 .1
-0 .02
Response of Consumption
to Inflation shock
Response of Wealth
to Inflation shock
0 .8
0 .15
0 .6
0 .1
0 .4
1
2
3
4
5
6
7
8
9
10
11
0 .05
12
0 .3
0 .2
0
0
1
-0 .04
1
0 .2
2
3
4
5
6
7
8
9
10
11
12
- 0 .1
0
1
2
3
4
5
6
7
8
9
10
11
-0 .2
3
4
5
6
7
8
9
10
11
4
5
6
7
8
9
10
11
12
11
12
-0 .1
-0 .08
-0 .3
2
3
12
-0 .2
1
2
-0 .05
-0 .06
0 .1
0
Response of Interest
to Inflation shock
-0 .1
-0 .4
-0 .15
-0 .6
- 0.2
12
-0 .1
-0 .4
-0 .12
Response of Inflation
to Income shock
0 .0 6
Response of Income
to Income shock
Response of Consumption
to Income shock
0 .15
1.5
0 .8
1.2
0 .0 4
Response of Wealth
to Income shock
Response of Interest
to Income shock
0 .1 4
0 .1 2
0 .6
0 .1
0 .9
0.1
0 .4
0 .0 2
0 .05
0 .0 8
0 .6
0 .2
0
0 .0 6
1
2
3
4
5
6
7
8
9
10
11
12
0
0 .3
1
2
3
4
5
6
7
8
9
10
11
12
0
-0 .0 2
1
0
-0 .05
1
-0 .0 4
2
3
4
5
6
7
8
9
10
11
2
3
4
5
6
7
8
9
10
11
12
0 .0 4
-0 .2
12
0 .0 2
-0 .3
-0 .4
0
-0 .1
-0 .6
-0 .0 6
1
-0 .6
-0 .0 2
-0 .8
-0 .0 4
2
3
4
5
6
7
8
9
10
-0 .15
-0 .9
-0 .0 8
Response of Inflation Response of Income
Response of Consumption Response of Wealth Response of Interest
to Consumption shock
to Consumption shock to Consumption shock to Consumption shock to Consumption shock
0 .0 4
0.2
0 .6
0 .15
0 .5
1
0 .0 6
0 .8
0 .0 2
0 .0 4
0 .4
0 .1
0 .6
0
0 .0 2
0 .3
1
2
3
4
5
6
7
8
9
10
11
12
0 .05
0 .4
0 .2
-0 .0 2
0
0
1
-0 .0 4
2
3
4
5
6
7
8
9
10
11
12
1
0 .2
0 .1
-0 .05
-0 .0 6
2
3
4
5
6
7
8
9
10
11
12
- 0 .1
-0 .15
-0 .2
- 0.2
-0 .3
-0 .0 8
Response of Inflation
to Wealth shock
Response of Income
to Wealth shock
0 .25
0.2
0 .1 2
0 .15
1
2
3
4
5
6
7
8
9
10
11
4
5
6
7
8
9
10
11
12
11
12
11
12
12
-0 .0 4
-0 .2
- 0.1
0 .1 4
3
0
1
-0 .1
0 .1 6
2
-0 .0 2
0
-0 .4
-0 .0 6
-0 .6
-0 .0 8
Response of Consumption
to Wealth shock
0.3
Response of Wealth
to Wealth shock
3
0 .25
Response of Interest
to Wealth shock
0 .1 4
2 .5
0 .1 2
0.2
2
0.1
0 .15
0.1
0 .1
1.5
0 .1
0 .0 8
0 .05
0 .0 8
1
0 .05
0 .0 6
0 .0 6
0
0 .0 4
-0 .05
0
1
0 .0 2
2
3
4
5
6
7
8
9
10
11
12
0 .5
1
2
3
4
5
6
7
8
9
10
11
12
0 .0 4
-0 .05
0
-0 .1
-0 .1
1
2
3
4
5
6
7
8
9
10
11
12
0 .0 2
-0 .5
-0 .15
0
0
-0 .15
1
2
3
4
5
6
7
8
9
10
11
12
-0 .0 2
-1
- 0.2
1
- 0.2
Response of Inflation
to Interest shock
0 .12
Response of Income Response of Consumption
to Interest shock
to Interest shock
0 .15
0 .1 4
3
4
5
6
7
8
9
10
Response of Wealth Response of Interest
to Interest shock
to Interest shock
0 .5
1.2
0 .1 2
0 .1
2
-0 .0 2
0 .45
1
0 .1
0.1
0 .4
0 .8
0 .0 8
0 .05
0 .08
0 .35
0 .6
0 .0 6
0 .3
0 .0 4
1
0 .0 2
2
3
4
5
6
7
8
9
10
11
0 .25
12
0 .2
0 .2
-0 .05
0
0 .04
0 .4
0
0 .06
1
2
3
4
5
6
7
8
9
10
11
0
12
-0 .0 2
-0 .0 6
0
-0 .15
-0 .0 8
1
2
3
4
5
6
7
8
9
10
11
12
0 .15
1
-0 .1
-0 .0 4
0 .02
- 0.2
Note: The dashed lines represent one-standard-error bands.
-0 .2
2
3
4
5
6
7
8
9
10
11
12
0 .1
-0 .4
0 .05
-0 .6
0
1
2
3
4
5
6
7
8
9
10
13
Response of consumption to short-term interest rate shock: baseline and
counterfactual scenarios
0.15
0.1
0.05
0
1
2
3
4
5
6 7
8 9 10 11 12
-0.05
Impact including
wealth effect
Impact excluding
wealth effect
-0.1
-0.15
-0.2
Note: The dashed lines represent one-standard-error bands.
14
Forecast error variance decomposition of consumption
Period
1
2
3
4
5
6
7
8
9
10
11
12
Inflation
1.1954
1.3488
2.2921
2.4634
2.6008
2.6453
2.6648
2.6717
2.6727
2.6725
2.6716
2.6710
Income
1.9007
2.1929
2.5239
2.7582
2.8555
2.8947
2.9118
2.9148
2.9171
2.9164
2.9164
2.9157
Cons umption
84.3481
77.7007
75.0414
74.6657
74.1844
74.1208
74.0049
73.9769
73.9330
73.9110
73.8865
73.8692
Wealth
8.3120
13.4121
14.2231
14.2507
14.3336
14.3182
14.3223
14.3153
14.3120
14.3078
14.3045
14.3015
Interest
4.2439
5.3454
5.9196
5.8620
6.0257
6.0209
6.0962
6.1213
6.1652
6.1924
6.2210
6.2426
15
7. Empirical Results: Asymmetry
•
To test for asymmetric effects, we present a set of OLS estimations for
the consumption function in terms of growth rates with appropriate
diagnostic checks.
•
Model 1 is a simple consumption function where consumption depends
on lagged income and wealth (Campbell and Mankiw, 1989). The
estimates suggest that while consumption is not significantly affected by
income, it is significantly impacted by wealth changes.
•
Model 2 adds interest rate to the consumption function. The estimates
show that in line with expectations, consumption is negatively affected
by interest rate changes, while the other results remain unchanged.
•
Model 3 introduces tight and easy monetary policy dummies. The
estimates suggest that while the interest rate increase dummy has an
insignificant coefficient, the interest rate decrease dummy has a positive
and significant coefficient. Thus this coefficient serves to reduce the
negative impact of interest rate on consumption during periods of tight
monetary policy. In other words, while consumption responds positively
to interest rate cuts, during periods of tight monetary policy
consumption does not decline as a response to higher interest rates.
16
• Model 4 expresses consumption in terms of lagged income, interest
rate and wealth – where the wealth series is split into wealth
increases and decreases. The estimates reveal that while wealth
increases serve to significantly raise consumption, fall in wealth
does not appear to have affected consumption as evidenced by the
insignificant coefficient of the wealth reduction series. In other
words, an explanation for why interest rate hikes may not lead to fall
in consumption expenditure may be found in the consumptionwealth relationship.
• In sum, while increases in wealth lead to higher consumption,
reductions in wealth do not affect consumption as households are
reluctant to lower their standards of living and expenditure even in
the face of adverse interest rate or wealth shocks.
17
Asymmetry in Consumption-wealth channel
Dependent variable is Consumption
Intercept
Cons umption(-1)
Income(-1)
Wealth(-1)
Wealth increase(-1)
Wealth decrease(-1)
Interest rate(-1)
Interest rate increase
dummy(-1)
Interest rate
decrease dummy(-1)
Adjusted R-squared
Akaike info criterion
Schwarz criterion
F-statistic
Durbin-Watson test
stat
Jarque-Bera test stat
ARCH LM test stat
Model 1
Coefficient P-value
0.7735
0.0000
-0.3086
0.0116
-0.0070
0.8854
0.0769
0.0013
Model 2
Coefficient P-value
1.2252 0.0000
-0.3492 0.0043
-0.0015 0.9742
0.0726 0.0020
-0.0730
0.1918
1.4029
1.5426
5.6681
1.8783
0.0116
1.2073
0.0018
0.9942
0.3192
0.2301
1.3697
1.5443
5.4083
1.9040
0.1384
0.9275
0.0569
0.0010
0.9331
0.4554
Model 3
Coefficient P-value
1.1582
0.0000
-0.3576
0.0030
-0.0095
0.8379
0.0564
0.0192
-0.0766
0.3277
0.0425
0.0427
0.1119
0.4183
0.2612
1.3582
1.6025
4.4759
1.9422
0.2776
0.9639
0.0010
0.8704
0.4353
Model 4
Coefficient P-value
1.1752
0.0000
-0.3492
0.0041
-0.0112
0.8131
0.1053
0.0084
-0.0794
0.2396
1.3723
1.5818
4.7178
1.9544
0.5505
0.6363
0.0028
0.8770
0.0393
0.0012
0.7594
0.6389
18
8. Policy Implications
•
There is evidence in the UK, and possibly elsewhere (Australia and US to
be tested) of asymmetric effects of monetary policy induced by interest rate
changes.
•
We find evidence that, at least in the short run, the consumption wealth
channel may explain this due to effects explored in the behavioural finance
literature and easier access to consumer credit (debt).
•
Given asymmetry, central banks (especially in more advanced financial
systems) need to take account of the likelihood that raising interest rates
may not reign in consumption growth to the extent anticipated (when
symmetry is assumed), especially in periods of accelerating asset price
inflation and relatively low real interest rates. Pre-emptive and progressive
interest rate increases may be required to dampen asset price increases
and contain future inflation.
•
In contrast, interest rate cuts may quickly provoke a stimulative effect.
•
As other countries’ financial systems develop, they may discover similar
effects.
19
The case of Philippines
•
•
•
To examine the effects of interest rate changes, we estimated a fourvariable SVAR (Inflation, GDP, Consumption, Interest) as data on
wealth was not available
Response of consumption to interest rate shock: Impulse response
function is not statistically significant as the standard error bands
appear to straddle the x-axis
This indicates that impact of interest rate shock on consumption is
not substantial (although we need to check for GARCH effects in
error term as suggested by diagnostic tests)
Response of consumption to
short-term interest rate shock
0.3
0.2
0.1
0
-0.1
1
2
3
4
5
6
7
8
9
10
11
12
-0.2
-0.3
Note: The dashed lines represent one standard-error bands.
20
Consumption function for Philippines
•
•
•
Consumption function (in growth rates) was estimated with tight and easy
monetary policy dummies
Maximum-likelihood estimates with GARCH(1,2) errors as suggested by
diagnostic tests
While this model shows negative dependence of consumption on interest
rate, but the coefficients of the dummies are statistically insignificant
indicating absence of asymmetric effects
Coefficient P-value
Intercept
4.8979
0.0000
Consumption(-1)
-0.0185
0.3498
GDP(-1)
0.0203
0.2937
Interest rate(-1)
-0.1260
0.0000
Interest rate
increase
dummy(-1)
0.1591
0.5165
Interest rate
decrease
dummy(-1)
-0.2371
0.3135
Intercept
RESID(-1)^2
GARCH(-1)
GARCH(-2)
(Variance Equation)
0.0440
0.2240
0.9289
0.0112
-0.0162
0.9125
0.2283
0.0360
21