Solutions to the Inflation-Induced Instability in Housing Markets

Abstract

We use a model and show how inflation and mortgage loans based on nominal interest rates (NRMs), like FRMs, ARMs or IOs, are a source of instability for housing markets. NRMs allocate risk inappropriately and cause economic tensions due to the tilt effect (Lessard and Modigliani, 1975), the costs to hedge the inflation rates (Lessard and Modigliani, 1975) and the unpredictability of inflation and price levels (Modigliani, 1974). Real Rate Inflation-Indexed Mortgages (RIMs), or mortgage loans that are inflation indexed and bear a reference to real interest rates, allocate risk more appropriately, lessen economic tensions and diminish the markets granted loans range and volatility. RIMs offer a significant advantage over NRMs. In contrast to inflation and nominal interest rates, markets can have reasonable expectations about the long-term trend of real interest rates and the natural interest rate, helping them to shape reasonable house prices and to reduce the negative effects of volatility and uncertainty. It also facilitates the introduction of new financial facilities and regulatory measures that could help to increase market stability.Results do not explain the market reluctance to indexed-loans. A bad assessment of the influence of inflation volatility, mainly in low-inflation countries, the ignorance of the benefits of the long-term trend of real interest rates, the lack of product development and a “Stag hunt game” situation may help to explain it. We finally show how the effects predicted by our model occurred in the US housing market between 1973 and 2009. Results encourage the promotion of RIMs for housing markets.