Interest Rates, Mortgage Refinancing and Consumption
This is a discussion in a comment thread which I think is worth pulling back. I claimed (as I often do) that interest rates do not have noticeable effects on consumption. Please notice the “noticeable” — it is an appeal to standard econometric analysis of aggregate time series.
OK the discussion
EMichael
January 16, 2015 10:14 am
Reason,
One other thought while readily admitting I am out of my element here.
A couple of weeks ago I did a private refi for a buddy of mine. He was at 7.5% on 300gs, paying PI of $2084 a month. Now he is at $1578 while keeping the term the same at 4%.
That is $500 a month of potential consumption caused by low interest rates. And knowing my buddy, he will spend it. đ
part of my reply
I will claim that consumption (as officially defined) is not noticeably correlated with interest rates. The key word is ânoticeablyâ. I assume that EMichaelâs friendâs consumption will increase. However, as far as I know, the effect of such events on aggregate consumption is so small that it doesnât show up in the aggregate data.
The correlation between the achieved 3 month real interest rate and the consumption disposable income ratio is -0.13. OK I should look at the mortgage rate, but this is a blog comment.
Always I am discussing how to model the economy. I donât claim that my story is a complete description of everything which happens in the economy. I am discussing which effects are small enough that they can be neglected when modelling.
Coberly
January 16, 2015 6:07 pm
Robert
i would guess that while emichaelâs friendâs consumption would increase
(unless paying interest is âconsumingâ a financial product), the guy collecting the interest would decrease his consumptionâŚ. unless he got paid off and so increases his consumption with the money he now has ânot lent.â in that case maybe the new mortgage holder would have less consumption than the firstâŚ
update: the interesting comments continue. Marko knows a lot more on the topic than I do.
Marko
January 17, 2015 4:38 am
You might have better luck seeing an effect if you looked at durables â and , more specifically , auto sales. A common use of a sizable windfall via mortgage refi seems to be splurging on a new set of wheels. Another common use is paydown of high-interest debt , like credit cards , which doesnât increase current consumption , but bodes well for consumption in the future ( assuming that lower debt load households will tend to consume more than higher debt load hhs ) .
Also , you have to consider the after-tax impact of lower mortgage payments â you probably only get about 70-75% bang for the buck after tax , which makes for a pretty good hit to ânoticeabilityâ.
A couple of recent papers :
http://www.nber.org/papers/w20561
http://www.voxeu.org/article/low-interest-rates-can-boost-households-consumption
– See more at: http://angrybearblog.strategydemo.com/2015/01/interest-rates-mortgage-refinancing-and-consumption.html#comment-2538304
End update
My long confused and confusing reply to Coberly after the jump (and down in the thread)
Robert Waldmann
January 16, 2015 10:48 pm
This comment thread is getting interesting enough to maybe pull back to the blog somehow.
@Coberly it is true that in standard mainstream macro new Keynesian DSGE models refinancing doesnât affect consumption. Consumption is modelled as the choice of a large number of identical people (called the representative agent) who have average income, wealth and consumption. This means that the mortgage interest nets out.
However, such models are not realistic.
Sticking with the discussion of the meanings of words (not the interesting part of the thread) I note your odd use of the word âguyâ. This is normally used to refer to a human being. But the mortgages in question belong first to a bank then are packaed and sold to ⌠well in the end probably a pension fund or maybe a very rich guy.
In the standard models (at least those popular pre-2008) this doesnât matter, but in the real world it matters a lot.
The old Keynesian way of discussing this issue is the concept of the marginal propensity to consume â the effect of of a change in someoneâs income on their consumption. if debtors have a higher marginal propensity to consume than creditors, lower interest rates cause higher consumption (as the reduction in interest rates acts like a transfer from creditors to debtors).
Letâs pretend the bank didnât package the mortgage into a mortgage bond and just kept ownership (so much for reality). Then the reduced flow of mortgage payments are going to a firm. Some will go to shareholders as dividends and some wonât. In some simple models this shouldnât matter, but in reality it does. Undistributed profits arenât personal income (they should cause personal capital gains eventually). The fact that consumption is more correlated with personal disposable income than with GDP is a hint that undistributed profits have less effect on consumption than personal income.
Also the dividends may go to a defined benefit pension fund and so not appear as anyoneâs personal income. Finally, the dividends which go to individuals mostly go to wealthy individuals whose marginal propensity to consume is low.
Even old Keynesian models tended to ignore the distinction between stuff belonging to corporations and the personal belongings of the shareholders. Only when dealing with data was the distinction between GNP minus taxes and personal income minus taxes made (the difference is undistributed profits of corporations plus depreciation of capital which is ignored in GNP and GDP hence the G).
My this reply is getting long and confusing and probably confused. Iâd say the effect of refinancing on consumption is ignored entirely in widely used models for exactly Coberlyâs reasons. That more realistic models and evidence supporting them strongly suggests that there is an effect, and finally, the data on interest rates and aggregate consumption suggest that ignoring the effect is a reasonably approximation.
Finally a regression. Consinc is the ratio of consumption to disposable pesonal income. rmort is supposed to be the real interest rate charged on mortgages and is the standard 30 year conventional mortgage rate minus 4 times the past quarters consumer expenditure deflator inflation. Obviously the way I deal with inflation is absurd, but this is a blog post. Data on the mortgage interest rate is available only from 1971 on.
. reg consinc rmort
Number of obs = 173
R-squared = 0.0132
consinc | Coef. Std. Err. t
rmort | -.0009941 .0006577 -1.51
_cons | .8957366 .0037146 241.14
here is the scatter
In my heart, I am sure interest rates affect consumption through mortgage financiing. But the aggregate data (analysed in a maybe ok for a blog post level) suggest that this isn’t a big deal.
Note that on the flip side some folks in Europe who borrowed using a Swiss Franc mortgage in Hungary and Poland, just got a 22% increase in their payments. The post raised the question of what these folks were smoking, in not propery assessing the risks, likley by mortgage sales types who took after the folks in the US in 2004-2007, that is lie as much as possible to get your big fees.
You might have better luck seeing an effect if you looked at durables – and , more specifically , auto sales. A common use of a sizable windfall via mortgage refi seems to be splurging on a new set of wheels. Another common use is paydown of high-interest debt , like credit cards , which doesn’t increase current consumption , but bodes well for consumption in the future ( assuming that lower debt load households will tend to consume more than higher debt load hhs ) .
Also , you have to consider the after-tax impact of lower mortgage payments – you probably only get about 70-75% bang for the buck after tax , which makes for a pretty good hit to “noticeability”.
A couple of recent papers :
http://www.nber.org/papers/w20561
http://www.voxeu.org/article/low-interest-rates-can-boost-households-consumption
@Marko
Wow thanks for the links.
The thing about the timing of Mortgage Equity Withdrawal spending is that big items:(cars, Remodels, big vacations) tend to be bought after the equity is “freed” and small items (dinner out, etc) tend to be done BEFORE the MEW via paying off credit card debt that is the result of spending more than one’s income. An argument can be made that one reason that the crash of the RE bubble was so bad for the economy was that in the prolonged low interest rates after the tech bubble crash, people’s spending adjusted to include periodic refinancing as part of their effective INCOME. So when the crash came , not only did economic activity go down because of actual income declines, but the “shadow income” of MEW disappeared AND that existing debt had to be serviced as CC debt at much higher rates than people were able to pay.
“The old Keynesian way of discussing this issue is the concept of the marginal propensity to consume â the effect of of a change in someoneâs income on their consumption. if debtors have a higher marginal propensity to consume than creditors, lower interest rates cause higher consumption (as the reduction in interest rates acts like a transfer from creditors to debtors). ”
Now this I totally agree with. I also see the problems with determining whether the increase in consumption is significant. My one rule of economics is “nothing happens until somebody buys something”, and I think the marginal propensity to consume is the important part of that puzzle. The debt holders are not going to spend that money they were previously earning, at least not in any meaningful amount.
I do have a question for Marko regarding ” you probably only get about 70-75% bang for the buck after tax , which makes for a pretty good hit to ânoticeabilityâ. ”
I am wondering where that percentage comes from. Is that from the loss of mortgage interest deduction? Cause that amount is pretty high as a marginal rate, especially considering that the vast majority of people barely receive much help from the MID due to its regressive nature.
And those that do receive such help probably have a much lower marginal propensity to spend.
Robert Waldmann,
âIn my heart, I am sure interest rates affect consumption through mortgage financiing. But the aggregate data (analysed in a maybe ok for a blog post level) suggest that this isnât a big deal.â
Perhaps a better way of thinking about this issue is to look at why interest rates have went up or down.
You are looking at data collected during the time period when the Fed was attempting to influence the economy by raising or lowering interest rates.
During most of the business cycle the Fed was concerned with avoiding inflation thus they tended to slowly move interest rates back up into what they thought was a ânormalâ range.
When the economy went into a recession the Fed slowly lowered interest rates which meant that consumers and corporations could get cheaper loans. Consumers would get a lower payment on his financed new vehicle. And automobile manufacturers could offer zero interest loans which also benefitted the consumer. Either way this would have effected consumption.
But would that be apparent in the data? If sales based on income are going down at the same time that the Fed is reducing interest rates, all you will see in the consumption data is the aggregated effect. (Sales based on income + sales based on increased borrowing)
Another consideration is that the economy after 2007 has not been normal.(Compared to other post war periods.) Household Debt peaked in the 3rd quarter of 2008 at $12.675trillion, then dipped to a low in the 2nd quarter of 2013 at $11.153trillion. By the 3rd quarter of 2014 it had gotten back up to $11.71trillion. Consumer debt is growing much slower now, when compared to the period from 2003 to 2008. Perhaps consumers are maxed out on debt.
Data from: http://www.newyorkfed.org/microeconomics/hhdc.html#/2014/q3
Click on âDownload Dataâ at bottom right of page.
Robert Waldmann,
Clarifying my comment above, the period from 2004 to 2008 was not normal either. Households were still rapidly accumulating debt during that period.
That rapid accumulation of household debt had begun before 1999 when total household debt was $4.54trillion in the 1st quarter.
From:http://www.newyorkfed.org/microeconomics/data.html
Click on â1999-2003 Dataâ above the 2014 table on the left.
Total household debt would increase to $12.675trillion in the 3rd quarter of 2008. An increase of over $8trillion.
Based on the Greenspan/Kennedy study of equity extraction, I believe that the rapid increase in household debt began in earnest about 1996.
I wonder if the dip in household debt from 2008 consists of foreclosures?
As an old finance guy(glorified salesman) it is not the debt that matters to me, it is the payments.
A household paying 28% of its gross income on their mortgage with a debt of $300,000 is in better position than if they were paying 28% of their gross income on a $250,000 mortgage. Yet their debt is obviously higher.
And I believe that mortgage debt is around 75% of all household debt.
Emichael mortgage debt was about 75% of all household debt in 2009. Now the ratio is down to about 65%. I am pretty sure that a large fraction of the decline in mortgage debt is due to foreclosures but I forget where I read that.
JimH the consumption related variable is the ratio of consumption to personal disposable income. That actually is pretty stable around the business cycle. Consumption declines a lot less than GDP in recessions but a very large part of the extra decline in GDP is of two parts of GDP which aren’t personal disposable income — undistributed profits and taxes.
Maybe I should have included the time series of the 2 variables as well as the scatter. The very high mortgage rate minus lagged inflation was mid 80s when Volcker was fighting inflation, had gotten the inflation rate well below the late 70s high but was still keeping short term interest rates high.
“I do have a question for Marko regarding â you probably only get about 70-75% bang for the buck after tax , which makes for a pretty good hit to ânoticeabilityâ. â
I am wondering where that percentage comes from. Is that from the loss of mortgage interest deduction? Cause that amount is pretty high as a marginal rate, especially considering that the vast majority of people barely receive much help from the MID due to its regressive nature….”
EMichael ,
That figure came off the top of my head , so it may well be off the mark. I do know that the vast majority of the MID dollars claimed are by taxpayers in the 25% and above categories , i.e. middle-class and up. Then there’s the additional state tax increment , which varies by state.
You’re right , though , that the bang for buck should be higher for lower-income MID claimers , both due to the reduced tax effect as well as their higher propensity to consume. This may be offset somewhat by their propensity to carry high-interest credit card debt and such , which they might pay off first before any increase in consumption shows up.
Bottom line – my number was just a guess.
Robert Waldmann,
Okay I see that you were using consumption / disposable income. I guess this is what you wanted to measure the âpropensity to consumeâ.
So you are scatter plotting a percentage of disposable income against interest rates which seems to range from about 0.86 to 0.94. In 2005 the difference between those two ratios would amount to about $754billion and that would be multiplied in the overall economy.
But that doesnât seem to get at âIn my heart, I am sure interest rates affect consumption through mortgage financiing.â in your last paragraph.
This plot does not seem to concern itself with the percentage of consumption due to increased or decreased borrowing. Perhaps you want the change in consumption vs the change in interest rate? (With all the faults that come with that.)
Using FRED I plotted (PCE/DPI)*200)-169 as (A). Adjust the period to start at 1980 for a better display. Then I added a plot for Effective Fed Funds Rate as B. Between about December 1982 and July 2005 when B decreases A increases. Though the noise seems to indicate there are other factors involved.
By December 2007 consumers had maxed out their debt, in the aggregate, so dropping the Effective Fed Funds Rate could not raise consumption and it actually fell.
In the Greenspan/Kennedy study of equity withdrawal from homes. See line 1 in Table 2 on page 16 and 17:
http://www.federalreserve.gov/pubs/feds/2007/200720/200720pap.pdf
In 2005 the BEA reported DPI of $9.408trillion and the Greenspan/Kennedy equity withdrawal was $1.429trillion or about 15% of DPI. But $143.9billion of that new debt was used to pay off existing non-mortgage debt which leaves $1.285trillion or 13.7% of DPI. I suppose that could be reduced further if we subtract closing costs and home equity loan repayment.
The question is how much of that equity withdrawal was due to lower interest rates and how much was just due to more highly motivated borrowers enabled by the housing bubble?
Oops!
Replace this:
So you are scatter plotting a percentage of disposable income against interest rates which seems to range from about 0.86 to 0.94. In 2005 the difference between those two ratios would amount to about $754billion and that would be multiplied in the overall economy.
With this:
So you are scatter plotting a percentage of disposable income against interest rates. The percentage of disposable income seems to range from about 0.86 to 0.94. In 2005 the difference between those two ratios would amount to about $754billion and that would be multiplied in the overall economy.
It would seem to me that a guess is about where the complexity of this leads us, but I will agree that my thoughts on the effects on consumption by interest rates are over the top.
How many people have managed to refinance? It’s a one time event and requires that housing prices not be too depressed and that the one doing the refinancing has adequate income for the new mortgage. Are we talking about tens of thousands? millions?
Yes, cutting a major expense in one area – most people pay their mortgage out of the same budget and cash flow as they would pay their rent – does free up some income for spending in another area. Lower gas prices and ACA subsidies could also have a positive impact on spending, but a lot depends on other factors. In this economic climate, a lot of people, after springing for the refinancing costs, are likely to start saving up a bit of a buffer. (Or maybe they’ll switch over to name brand ketchup – http://www.theonion.com/articles/minimumwage-hike-celebrated-with-namebrand-ketchup,2253/)
Robert Waldmann,
Adding to this: “Using FRED I plotted (PCE/DPI)*200)-169 as (A). Adjust the period to start at 1980 for a better display. Then I added a plot for Effective Fed Funds Rate as B. Between about December 1982 and July 2005 when B decreases A increases. Though the noise seems to indicate there are other factors involved.”
The transitions in the plot for (PCE/DPI)*200)-169 are lagging the transitions in the plot for Effective Fed Funds Rate. That could be interpreted as cause and effect.
Thinking about this a bit more closely, it seems to me that:
1. Refinancing occurs with a lag in the US (look at Australia where mortgages are mostly adjustable rate as see if that looks different)
2. At the same time that some people are refinancing, some people are increasing their mortgage debt (and repayments). Maybe the two effects are cancelling each other out. (Of course this should be reflected in land prices.
Another issue, might be that mortgage rates tends to fall when income growth (and consumption growth) is weak and potentially getting weaker still. Maybe some reverse correlation is affecting the results.