At the same time, uncertainty about the effect of interest rate changes has increased, suggesting a cautious approach to interest rate setting. 4/7  BIS central bankers' speeches  The rise in interest rates affects consumption through various mechanisms. Some of these mechanisms operate with a lag. Household disposable income will be affected by slightly more subdued growth in employment and wages. Higher interest rates may also curb the rise in house prices, resulting in a smaller rise in housing wealth than would otherwise have been the case. Other consequences of an interest rate increase will have a more direct impact on private consumption. First, higher interest rates push up the cost of consumption today relative to consumption tomorrow. Debt-financed consumption becomes more costly, while saving provides a higher return, pointing towards lower consumption today. Credible signals that the interest rate will remain at a higher level ahead may amplify this effect. Second, the interest rate increase has a direct impact on household disposable income. The strength of this channel will depend on the overall debt level and the distribution of debt (Gerdrup et al (2018)). While higher interest rates means increased expenses for some, interest income increases for others. If housing wealth is disregarded, Norwegian households as a whole are in a net debt position. As higher interest rates means higher net interest expenses, a higher interest rate level will in isolation reduce household purchasing power. Chart: Household debt has increased The elevated debt level has amplified this effect.
This study finds that the relative decrease in consumption after a reduction in income, referred to by economists as the marginal propensity to consume, depends on households’ financial situation. The literature also refers to the “wealthy hand-to-mouth” (Kaplan and Violante (2018)), ie households with high incomes, illiquid housing assets and relatively high loan-to-value ratios. In the face of higher interest expenses, this group may well react by making a considerable adjustment in consumption. Chart: Debt and wealth vary through the life cycle 5/7  BIS central bankers' speeches  Households’ financial position can largely be inferred from the stage in the life cycle. The chart shows how assets and debt vary with age. On average, the highest level of debt is for households in the 30–40 age group. An interest rate increase will have the greatest impact on this group, which also has modest financial buffers. [6] This group’s wealth primarily comprises illiquid housing assets that may be difficult to draw on in hard times. Debt is lower for the older age groups. These groups include people who entered the housing market when house prices were lower. Since many have built up liquid wealth in the form of bank deposits or other kinds of assets, net interest income could increase for some. An interest rate increase would likely have a smaller effect on consumption in this group than in younger groups. The oldest age groups are virtually debt-free. Many older households have substantial housing wealth and money in the bank.