Housing Affordability, Interest Rates, and Inflation
Many thanks to AB for this paper and for posting Chart 6, which was accompanied by this discussion:
Taking into account the influence that declining nominal mortgage interest rates have on cash flow affordability leads to a quite different assessment of current home prices than does the simple home-price-to-income ratio. To demonstrate this, we compute the ratio between the annual principal and interest payments at prevailing mortgage rates on a constant-quality new single-family home (assuming a thirty-year, 80 percent loan-to-value [LTV] ratio loan) and median family income. This ratio has been relatively stable, around 15 percent, for several years, which is as low as it has been over the past twenty-five years (Chart 6).
Nominal mortgage rates were around 16% in 1980-1981 in part because expected inflation was near 10%. The NYFED paper notes that nominal mortgage rates are now closer to 6%, but then expected inflation is around 2%. So there are two reasons for the dramatic drop in this ratio: real interest rates are lower but mainly because expected inflation is much lower. The paper also notes the approximately 10% mortgage rates around 1990. Could one argue that expected inflation was near 4% then versus 2% now so half of the decline in nominal rates from 1990 to now was lower expected inflation and half was lower real rates?
This is a crucial aspect of the affordability issue if households can use expected nominal housing appreciation to finance borrowing, that is, if households are not liquidity constrained. Yes, I know this is not always true but homeowners in 1981 were borrowing to finance other forms of consumption. And the NYFED paper is careful to graph both nominal housing appreciation as well as real appreciation. Note in particular that housing prices continue to rise nominally during the early 1980’s even as relative prices declined.
So my suggestion for the authors of this paper might be to adjust chart 6 to reflect the inflation distortion inherent in looking at nominal interest rates. Of course, many argued even back in the early 1980’s that inflation was not neutral as households are liquidity constrained.