Why mortgages represent a dilemma for central banks

The argument against price stability

While inflation affects GDP, Dr. Sheedy argues that the variability of income has a much larger impact. The household debt in the U.S. upon which the alternate case is built is about $19.5 trillion to $28.5 trillion—much larger than the GDP of $16 trillion.

Mortgages are often long-term liabilities. When an individual buys a house on borrowed funds, their future monthly repayment for next 20 to 30 years is fixed on day 0. However, individuals lack forecasting ability to figure out if they can continue earning at levels where they’re in a position to meet the repayments. Economic shocks may result in lower income in future years than at the time when the mortgage payments commenced.

Dr. Sheedy argues that “income targeting” addresses a bigger problem than the approach of “inflation targeting.”

The model

Dr. Sheedy discusses the “counter cycle price level” policy to overcome the problem of household borrowers. The policy suggests that “interest rates should not be moved in response to shocks.” To put this in simple terms, the policy questions the conventional approach of increasing interest rates to counter high inflation. The model recommends keeping interest rates constant and equal to the long-term growth rate and to move prices upward or downward in response to shocks.

The policy is counter-cyclical because it recommends adjusting price levels in response to income levels.

So, as per the policy, as the income levels rise, prices should drop to keep the gross real interest rate equal to the long-term growth rate.

In the above equation, R is the gross real interest rate, P (t+1) is price at time t +1, P(t) is price at time t, w(t+1) equals wages (income levels) at time t+1 and w(t) equals wages at time t.

As per the model, increases in wages (income levels) should result in decreases in prices to maintain R = long-term growth rate. So there could be a deflationary scenario if wages increase!

The phenomenon is exactly opposite to what we observe in the economy. As income levels rise, people have more money to spend, resulting in a tendency of paying more for the same goods than they did earlier. The tendency leads to inflation. Central banks then raise interest rates to control the tendency by discouraging spending. Rises in interest rates affect bond markets (BND), particularly Treasury securities (TLT). The rise in interest rates also affects other asset classes, such as high-yield bonds (HYG). Rising interest rates are a negative indicator for the housing and construction sector, affecting companies like Home Depot (HD) and Lowe’s (LOW).