Investing.com - RBA's Assistance Governor Chris Kent gave a speech on Wednesday, outlining the effects of policy tightening measures on demand and inflation.
In the speech, Kent noted that the most significant impact of these cash rate hikes is through the cash-flow channel. Higher cash rates mean increased interest payments for those in debt, which subsequently reduces disposable income, leading to slower demand growth and an eventual decrease in inflation.
The effect through the cash-flow channel is immediate for borrowers with variable-rate debt, but those with fixed-rate debt feel it with a delay. Currently, many households and businesses are experiencing significant financial strain due to their debts, a burden that only a section of the population bears. However, other channels of monetary policy have wider effects.
The effect of monetary policy on the economy is three-fold – it influences a range of interest rates starting from the cash rate, affects economic activity, and eventually impacts inflation. Five main channels of monetary policy play crucial roles in reducing inflation in Australia.
The cash rate, which is the interest rate banks pay when borrowing from other banks overnight, directly influences other interest rates throughout the economy. Any changes in the cash rate directly impact banks’ funding costs, and this effect is passed on to borrowers with variable-rate debt.
Banks have passed on much, though not all, of the rise in the cash rate to depositors. Since May 2022, Australian banks have transferred about 75% of the cash rate increase to deposits, a pass-through rate relatively high compared to other economies.
Long-term interest rates are less closely tied to the cash rate. Factors such as offshore yields and expectations for the cash rate and inflation in the future also affect long-term rates.
Monetary policy impacts economic activity and inflation through five channels: the cash-flow channel, the intertemporal substitution channel, the asset price channel, the credit channel, and the exchange rate channel.
The cash-flow channel is the most evident in Australia, where the rise in interest rates has increased incentives to save, even for households that had accumulated a lot of extra savings during the pandemic.
These channels of monetary policy are slowing the growth of demand and contributing to a decline in inflation.
Kent also noted that policymakers are closely monitoring economic developments domestically and globally, and further tightening of monetary policy may be necessary to ensure that inflation, which is currently too high, returns to the target in a reasonable timeframe.