Prices vs. inflation and a mortgage puzzle

Mickey Levy's excellent WSJ oped leaves some thoughts. 

Inflation has fallen, though I still suspect it may get stuck around 3-4%. But prices "are 18.9% higher than its [their] pre-pandemic level." And some important prices have risen even more. "Rental costs continue to rise in lagged response to the 46.1% surge in home prices."  Those who are taking a victory lap about the end of inflation (the rate of change of prices) are befuddled by continuing consumer (and voter) anger. 

Well, prices are not the same thing as inflation.

Our current monetary policy has, for decades, forgotten past mistakes. If inflation surges to 10%, and prices rise 10%, it is considered a victory, and battle over when inflation gets back to 2%, though prices are still 12% higher than they were. It wasn't always this way. Under the gold standard, prices were stable for long periods, which means that bouts of inflation were quickly followed by bouts of deflation. I'm absolutely not advocating for the gold standard, but it's worth remembering that price stability rather than inflation stability is possible.  

Why the fuss? As Mickey points out, not all prices rose the same amount. In particular, "Increases in wage and salaries ... haven’t kept pace with the CPI and have resulted in a decline in real wages." No wonder "the public isn’t pleased." 

This offers an interesting moment to rethink the basic idea of bygones will be bygones in monetary policy. Wages are, by common agreement, a lot more sticky than prices. Eventually wages will catch up, but it will be a long and contentious process. Wouldn't it be better, after a bout of inflation, for prices to come down quickly,  to match the current level of nominal wages? "Real wage restoration" has a nice ring to it that even Fed doves and inequality worriers might appreciate. 

Mortgages

Mickey also points to a fascinating puzzle of our mortgage markets: 

Tens of millions of homeowners who locked in mortgages at rates below 3% between 2020 and 2021 are now unwilling to sell. The result is a shortage of homes on the market and higher prices. ..That in turn has impaired labor mobility, historically an important factor for production and labor-market efficiencies.

In the US, if you wish to protect yourself against rising mortgage interest rates by buying a fixed rate mortgage, you can only do it bundled with one particular house. You cannot easily say, "I don't want to get hit by interest rate rises, but I might want to move and still be able to afford a big house."  So we are stuck with this interesting puzzle, that higher interest rates to combat inflation lead to people staying parked in houses they really don't want, unwilling to move to take a better job somewhere else, to downsize, to cash out of a house-poor expensive area (Palo Alto), to upsize for more children or elderly parents, and so on. 

30 year fixed rate non-transferrable mortgages with a complex option to prepay and refinance when interest rates go down, and little consequence for default (whew)  are not a law of nature. It is not this way around the world, and I've been fascinated to talk to economists at other central banks about their very different worries. 

In many countries almost all mortgages have floating rates, that quickly catch up to any rise in short term interest rates. In many of these countries, it is not easy to default. If interest rates rise from 2% to 6% and you can't afford to triple your monthly payment, you can't just give the bank the keys as you typically can in the US. In Sweden, I was told,  if you default on a mortgage, the bank will grab all your other assets, and also garnish your wages for several years. You will live on their minimum social assistance income, about $15,000 at the time of this conversation, for several years. 

As a result, central banks in these countries have a completely different set of worries about raising interest rates. Rather than worry about defaults that will imperil banks, they worry that people will stop spending on everything else before defaulting on their mortgage. So monetary policy (raising interest rates), surprisingly ineffective right now in the US, can be dramatically more "effective" with that sort of mortgage market. (Yes, inducing a fall in consumption is the point of raising interest rates.) I don't know of mainstream models that include this distinction but it seems first order for the effect of interest rates on the economy. Central bankers also worry a lot more about public backlash when mortgage costs for the whole population can swiftly double or more. 

Back to the US. Why can you not keep your mortgage when you change houses? Why must protection against interest rate rises -- a form of insurance, really -- be tied to staying in one house? 

Put that way, you can come up with a dozen legal, regulatory, and perhaps even economic reasons. The 30 year fixed rate itself is an invention of 1930s federal housing policy. Banks hold very few mortgages. Pretty much the whole mortgage market gets securitized with a credit guarantee by federal housing agencies (Fannie, Freddy, etc.). So if their rules for acceptable mortgage says you can't change houses, well, you can't change houses, no matter what demand. Subsidies for a particular version of a product kill product innovation. One real estate economist I asked this of suggested that the mortgage originators like it this way, as it forces you to pay fees to move. And one can speculate that lenders don't want you to substitute a worse house as collateral. I don't think that holds, because acceptability of the house follows simple rules, but it's possible. 

So, today's bright idea: Why don't banks also routinely sell retail fixed for floating swaps? These are standard financial contracts that have been around for decades. Here's how it works: You take out a floating rate mortgage, at say 2%. Fixed rate mortgages are, say, 3%. So along with your mortgage, you agree with the bank that you will pay the bank 3% a year, fixed for 30 years, and the bank will pay the floating mortgage rate. That's 2% now, but if interest rates rise, the bank has to pay 5% and you keep paying 3%. Now you can sell the house. When you get a new house, you use the floating rate (5%) to pay the new higher mortgage on the house, while you keep paying 3% out of pocket. We have synthesized a portable mortgage. 

Why doesn't this happen? I await your speculation in the comments. Banks trade fixed for floating swaps among themselves all the time, so laying off the risk is not hard. 

As usual, I am drawn to wonder what tax or regulation is in the way.  I can think of  a few. First, you will get the mortgage interest tax deduction only on the actual mortgage. The actual 3% fixed mortgage lets you deduct the whole 3%. You will pay income tax on fixed for floating payments. This is really an insurance payment, like fire insurance, which shouldn't be taxable, but the IRS will likely treat it as such. Perhaps if insurance companies sold the product they could lobby Washington for rules to extend the tax exemption,  but then you lose some of the efficiency of banks doing what is properly the business of banks. 

Heaven knows how bank regulators and consumer financial protection regulators will do to tangle up a perfectly sensible product. The Fed finally caved in to political pressure to put climate in financial regulation: 

 banks must manage their balance sheets for physical risks from climate change, such as flooding or drought, as well as the “stresses to institutions or sectors arising from the shifts in policy, consumer and business sentiment, or technologies associated with the changes that would be part of a transition to a lower carbon economy.”...

Shifts in policy? OK Citi, what will happen to your balance sheet if a Republican gets elected and cancels electric vehicle mandates? Oh, maybe that's not the "change in policy" banks are supposed to anticipate.  

Banks will also have to conduct a “climate-related scenario analysis”—don’t call them stress tests—that extend “beyond the financial institution’s typical strategic planning horizon” and account for potential losses in “extreme but plausible scenarios.” 

Well, if anvils fall from the sky... But I digress. With this sort of thing coming from regulators, who has the time to create and get approval for a new product that might actually serve homeowners and help to unlock housing supply in places where it's scarce? 

If you can think of other regulatory (or economic) barriers, comment away.  Or maybe, just maybe, we're waiting for a sharp fintech company to figure out that floating + swap is a product consumers would want. 

(Swaps also require counterparties to post collateral, i.e. put in enough cash that the other side can be sure the payment stream keeps going, and in the event of default come out even. On the household side, equity in the house should serve as it does for mortgages; it would be like a second mortgage claim on home equity. That's a reason to bundle retail swaps with the mortgage issuance. One could have banks post collateral too, though enough priority in bankruptcy should do the trick as these are retail contracts. )  

(The madness of refinancing fixed mortgages is also puzzling. I know a lot of very good financial economists, and not one can figure out the optimal time to refinance a fixed rate mortgage. Why not just sell mortgages that adjust down but not up? Sure, you'll pay a few basis points extra, but we save a lot of complexity and the costs of getting that option wrong. The same answers as above may apply.) 

Update:

I long ago proposed "health status insurance," which is insurance against health insurance premium increases. If you get sick and your health insurance increases, the premium insurance pays the higher health insurance, or a lump sum so you can do it. 

What I'm suggesting here is also  "mortgage rate rise insurance." Get a floating rate mortgage and separate mortgage rate insurance. If the mortgage rate rises, the insurance pays the higher rate, or a lump sum so you can do it. 

While we're at it, the major difference between buying and renting is that buying allows you to stay in the house no matter if rents go up, where renters bear the risk of higher rents. It's puzzling that you can get long-term commercial leases, but residential leases allow the rent to rise each year. Rent increase insurance could work the same way. Rent for a year, buy rent increase insurance, and if the rent goes up, rent increase insurance pays the difference or pays a lump sum so you can do it. (Renters synthesize this somewhat by renting and then voting in rent control!) 

Update 2:

As many commenters point out, another way to handle the problem is for borrowers to be able to buy their own mortgage back, as is done in Denmark.