Household debt and asset prices drive consumption response to rate cuts
Bank of England researchers estimate a 1 percentage point mortgage rate cut increases consumption by 3 percent over six months. Their study, using UK data, finds this effect is primarily driven by borrowing against higher house prices.
Fixed-rate expiry reveals consumption boost
A new Bank of England working paper estimates how interest rate cuts increase consumption, primarily through household debt and asset prices.
The researchers exploited the staggered expiration of fixed-rate mortgages in the United Kingdom, constructing six million household-level natural experiments using administrative data on mortgages and consumption.
They found that a 1 percentage point reduction in mortgage rates raises consumption by 3 percent in the six months following the rate change.
Crucially, this increase in consumption is mostly attributed to households borrowing against higher house prices, rather than solely from lower debt service costs.
This suggests that monetary policy significantly affects consumption through asset prices and increased borrowing capacity.
Asset prices outweigh debt service
The study distinguishes between two channels through which rate cuts affect consumption: the 'mortgage cash flow effect' (lower debt service) and increased borrowing capacity due to higher house prices.
The findings indicate that increased borrowing against asset prices accounts for approximately two-thirds of the total response of cash-on-hand after six months, making it the dominant mechanism.
The household debt channel is substantial, with a 1 percentage point rate cut potentially increasing aggregate consumption by around 0.7 percent of GDP if all mortgage deals expired simultaneously.
The paper also highlights that monetary policy impacts consumption with 'long and variable lags', taking about 50 months for the cumulative effect of rate cuts to fully materialize.
Asset prices: the real lever
This research offers crucial insights into monetary policy transmission, highlighting the underappreciated role of asset prices.
By isolating the impact of house price changes, the study provides a more nuanced understanding for policymakers beyond just debt service costs.
The findings underscore the need for central banks to consider wealth effects and housing market dynamics when assessing interest rate impacts.