Friday, July 18, 2008

Inflation and the Development of Mortgage Markets in Emerging Economies

Rising commodity prices have not just placed upward pressure on inflation in the US. In emerging markets, the impact is, in many cases, larger, with double digit inflation returning to places such as South Africa and Russia.

Inflation harms mortgage markets. Because nominal interest rates are high during periods of high inflation, payment-to-income ratios for even modest houses move beyond the means of what households can afford (and what lenders are willing to lend) in the short run. This problem is known as mortgage "tilt."

There are workarounds--for instance, price level adjustable mortgages (or PLAMS) charge real interest rates and then adjust the loan balance each period to reflect inflation. Unless these mortgages are carefully constructed, however, and unless the "correct" price index is known (and it rarely is), they are highly risky, because they have a negative amortization feature by construction. They are particularly problematic when house prices do not rise as rapidly as the general price level. The current US experience (as well as the 1980s) show that gaps between consumer prices and house prices can at times be large.

So the mortgage market is a case where nominal price changes can have real effects. It is no accident that the American mortgage market nearly disappeared during the late 1970s--a period of double digit inflation in the US.


Anonymous said...

And the 70's was a time of relatively high personal savings rate. Supposedly we have been at a negative savings rate for a number of years now.

This graph shows something strange happening in may of this year, but I doubt it reflects reality in light of all the credit problems coming home to roost and the fact that a 4% certificate of deposit gives you a negative real return on investment.

Anonymous said...

So get rid of inflation already. With a stable dollar, domestic savers will gradually start saving again in a form that can be loaned out. Nominal interest rates will be the same as real rates, so nominal rates can be as low as practical.

Constant inflation hurts people.

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