The Mortgage Credit Channel of Macroeconomic Transmission

This paper investigates if, how, and when mortgage credit growth propagates and amplifies shocks to the macroeconomy, and evaluates the implications of these dynamics for monetary and macroprudential policy. I develop a general equilibrium framework with endogenous prepayment decisions by borrowers and two credit constraints: a loan to-value constraint, and a limit on the ratio of mortgage payments to income. This realistic structure delivers powerful transmission from interest rates, into mortgage credit growth, house prices and aggregate demand. The keys to transmission are a constraint switching effect through which changes in which constraint binds for borrowers cause large movements in house prices, and a frontloading effect through which waves of prepayment transmit movements in credit limits into the real economy. Monetary policy is more effective at stabilizing inflation due to this channel, but contributes to larger fluctuations in credit growth. A relaxation of payment-to-income standards alone, calibrated to loan-level data, can generate roughly half of the observed increase in price-rent (43%) and debt-to household-income (53%) ratios, while relaxation of loan-to-value standards generates a much smaller boom. A cap on payment-to-income ratios, not loan-to-value ratios, is found to be the more effective macroprudential policy for limiting boom-bust cycles.