December 4th, 2018
“Mortgage Prepayment and Path-Dependent Effects of Monetary Policy”
How much ability does the Fed have to stimulate the economy by cutting interest rates to zero? We argue that the presence of substantial debt in fixed-rate prepayable mortgages means that this question cannot be answered by looking only at how far current rates are from zero. Using a household model of mortgage prepayment with endogenous mortgage pricing, wealth distributions and consumption matched to detailed loan-level evidence on the relationship between prepayment and rate incentives, we argue that the ability to stimulate the economy by cutting rates depends not just on current rates but also on their previous path: 1) Holding current rates constant, monetary policy is less effective if previous rates were low. 2) Monetary policy "reloads" stimulative power extremely slowly after raising rates. 3) The strength of monetary policy through mortgage prepayment has been amplified by the 30-year secular decline in mortgage rates. All three conclusions imply that even if the Fed raises rates substantially before the next recession arrives, it will likely have less ammunition available for stimulus than in recent recessions.