Does the Threshold for Household Debt Growth Matter for GDP Growth and the Response of Monetary Policy to Inflation Shocks?

This chapter assesses whether household debt growth regimes lead to subsequent lower output growth and higher unemployment. Mian et al. (2015) establish that household debt is a source of instability and lower economic growth. First, we establish that on a bilateral basis, household debt growth explains 60 per cent of changes in GDP growth. Second, the household debt growth threshold that exerts non-linear shock effects on output growth occurs around 9.62 per cent. Third, the household debt growth threshold matters for output growth, inflation and the monetary policy response to inflation shocks. The results show that the policy rate is tightened in the high household debt growth regime due to positive inflationary pressures. Furthermore, loose labour market conditions amplify the repo rate tightening in response to inflationary pressures in the high household debt growth regime. This means that household debt growth regimes transmit positive inflation shocks to the policy rate. Loose labour market conditions, household debt growth regimes and inflationary pressures interact and have an influence on the monetary policy settings. The amplification size by household debt growth in the high debt regime is nearly double that in the low debt regime. The policy implication is that the level of household debt (household debt regimes) as one of the indictors of household financial standing and financial stability plays a meaningful role in the price stability mandate and the responses of the policy rate. There is a strong link between the price and financial stability objectives of the central bank via the household debt channel.