* This paper was prepared for the ASIA-LINK human resource development project:

1. ASIA-LINK PROGRAMMEEuro-Philippines Network in Banking & FinanceEnhancing Teaching and ResearchAsialink/ASIE/B7-3010/2005/105-139RESEARCH CONFERENCE ONSAFETY AND EFFICIENCY OF THE FINANCIAL SYSTEM, 27th AUGUST 2007. This conference was organized with the support of the EU Asia-Link ProgrammeAsialink/ASIE/B7-3010/2005/105-139 coordinated by the University of Limoges (France)

2. ASYMMETRIC EFFECTS OF INTEREST RATE CHANGES: THE ROLE OF THE CONSUMPTION-WEALTH CHANNEL*Andy MullineuxProfessor of Global Finance(University of Birmingham)Garry McDonaldAssociate Professor(Curtin Business School) Rudra SensarmaMaxwell 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)

3. 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’).

4. 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.

5. 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.

6. ‘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.

7. 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.

8. 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.

9. 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.

10. Data are quarterly, from 1991:Q1 to 2006:Q2. • 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.

11. 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 consumption-wealth channel, the following procedure is used. • Estimate a five-variable SVAR with consumption, income, wealth, interest rate, inflation

12. 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)

13. 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%

17. 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.

18. 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 consumption-wealth 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.

20. 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.

21. The case of Philippines • To examine the effects of interest rate changes, we estimated a four-variable 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) Note: The dashed lines represent one standard-error bands.

22. 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