Inflation's hidden toll on home ownership and mortgage debt
A new Bank of Canada study reveals that changes in trend inflation have significant long-term real effects on home ownership and household debt. Higher nominal interest rates, driven by increased inflation, front-load real mortgage payments, thereby reducing home ownership and the mortgage debt-to-income ratio.
The non-superneutrality of money in housing
The research highlights that in an economy characterized by fixed-amortization mortgages and consumers facing borrowing constraints, the level of inflation targeted by central banks is not superneutral.
This means that changes in trend inflation have tangible real effects on key economic variables such as home ownership, overall consumption patterns, and household debt levels.
Specifically, higher trend inflation leads to an increase in nominal interest rates.
This, in turn, results in higher nominal mortgage payments at the point of origination.
For borrowing-constrained homeowners, these elevated initial payments crowd out non-housing consumption, forcing a reallocation of household budgets.
The study's life-cycle housing tenure choice model demonstrates that by front-loading real mortgage payments, higher inflation ultimately lowers the steady-state rate of home ownership and reduces the mortgage debt-to-income (DTI) ratio over the long term, reshaping household balance sheets and wealth accumulation.
Decades-long market adjustments
The study reveals that the housing market's adjustment to unanticipated permanent changes in trend inflation is remarkably slow, often taking up to 20 years for home ownership rates and the mortgage DTI ratio to reach a new steady state.
This extended transition period was evident following historical events such as the Volcker disinflation of the 1980s.
The paper also differentiates between the impacts on fixed-rate mortgages (FRMs) and adjustable-rate mortgages (ARMs).
While refinancing of FRMs can mitigate differences between these mortgage types after a fall in inflation, the mortgage lock-in effect associated with FRMs leads to a significantly longer transition period following an increase in inflation compared to ARMs.
In a calibrated economic model, the research attributes approximately half of the rise in US mortgage debt between 1983 and 2001 to the combined effect of falling inflation—from around 8 percent in the early 1980s to under 3 percent by 2000—and subsequently lower mortgage financing costs.
Beyond nominal figures
This research provides crucial insights into the often-overlooked real effects of monetary policy on household balance sheets.
While the long transition periods highlight the stickiness of housing market dynamics, the study's quantitative findings underscore the substantial impact of inflation on wealth distribution.
Policymakers must consider these long-term structural effects when setting inflation targets, as seemingly minor shifts can reshape the economic landscape for decades.