The Long Shadows of the Great Inflation: Evidence from Residential Mortgages

Abstract

A major puzzle in financial contracting is consumers' aversion to adjustable rates. In the mortgage market, the empirical mix of contracts (80% fixed-rate) is inconsistent with standard life-cycle consumption models. We argue that these choices reflect the longlasting effect of the Great Inflation, and have sizable welfare implications. First, we show that consumers who have experienced higher inflation expect higher future interest-rate increases, which explains their preference for fixed-rate financing. Next, we quantify the influence of personal inflation experiences on mortgage financing using linked data from the Census Bureau's Residential Finance Survey. We estimate a discrete-choice model over mortgage financing alternatives. The structural parameters indicate that one additional percentage point of experienced inflation increases a borrower's willingness to pay for a fixed-rate mortgage by 6 to 14 basis points, compared to the adjustable-rate alternative in a given origination year. This experience effect has a major impact on the product mix of FRMs versus ARMs: Nearly one in seven households would switch to an ARM if not for the longlasting effect of personal inflation experiences. Our simulations suggest that households who would otherwise have switched pay $8,000-$16,000 in year-2000, after-tax dollars for the embedded inflation protection of the FRM.