Housing and the Long-Term Real Effects of Changes in Trend Inflation

An economy with fixed-amortization mortgages and borrowing-constrained consumers leads to the non-superneutrality of money as the level of inflation targeted has real effects on home ownership, consumption, and debt. Higher trend inflation increases nominal interest rates, which increases nominal mortgage payments at origination and crowds out non-housing consumption by borrowing-constrained homeowners. Using a life-cycle housing tenure choice model where trend inflation proportionately shifts nominal income growth and interest rates, we show that by front-loading real mortgage payments, higher inflation lowers steady-state home ownership and the mortgage debt-to-income (DTI) ratio. After an unanticipated permanent change in trend inflation, such as the 1980s Volcker disinflation, it can take 20 years for home ownership and the DTI ratio to reach the new steady state. While refinancing of fixed-rate mortgages (FRMs) narrows the differences between economies with FRMs and those with adjustable-rate mortgages (ARMs) after a fall in inflation, the mortgage lock-in effect leads to a longer transition following an increase in inflation with FRMs than ARMs. In our calibrated economy, the fall in inflation from around 8% in the early 1980s to under 3% by 2000, combined with lower mortgage financing costs, can account for half of the rise in US mortgage debt between 1983 and 2001.