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«Abstract Do households bene.t from expansionary monetary policy? We investigate how indebted households’ consumption and saving decisions are ...»

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Monetary Policy Pass-Through:

Household Consumption and Voluntary Deleveraging

Marco Di Maggio Amir Kermani Rodney Ramcharan

Current Draft: November 2014

Abstract

Do households bene…t from expansionary monetary policy? We investigate how indebted

households’ consumption and saving decisions are a¤ected by anticipated changes in monthly

interest payments. We focus on borrowers with adjustable rate mortgages originated between

2005 and 2007 featuring an automatic reset of the interest rate after …ve years. The monthly payment due from the average borrower falls by 52 percent ($900) upon reset, resulting in an increase in disposable income totaling tens of thousands of dollars over the remaining life of the mortgage. We uncover three patterns. First, the average household increases monthly car purchases by 40 percent ($150) upon reset. Second, this expansionary e¤ect is attenuated by the borrowers’voluntary deleveraging, as a signi…cant fraction of the increased income is deployed to accelerate debt repayment. Third, the marginal propensity to consume is signi…cantly higher for low income and underwater borrowers. To complement these household-level …ndings, we employ county-level data to provide evidence that consumption responded more to a reduction in short-term interest rates in counties with a larger fraction of adjustable rate mortgage debt.

Our results shed light on the income channel of monetary policy as well as the role of debt rigidity in reducing the e¤ectiveness of monetary policy.

We thank Daron Acemoglu, Patrick Bolton, Luigi Guiso, Adam Guren, Tullio Jappelli, Chris Mayer, Claudio Michelacci, Emi Nakamura, Marco Pagano, Jonathan Parker, David Romer, Jón Steinsson, Suresh Sundaresan, Nancy Wallace, James Wilcox, Daniel Wolfenzon, Steve Zeldes, and seminar participants at the NBER Monetary Economics Fall meeting, Cornell University, University of Toronto, EIEF and Federico II University of Naples for helpful comments. We are grateful for …nancial support from the NBER Household Finance Grant. We also thank Katrina Evtimova, Jeremy Oldfather and Calvin Zhang for outstanding research assistance. All remaining errors are ours. The views in this paper do not necessarily re‡ those ect of the Federal Reserve System. Di Maggio: Columbia Business School (email: mdimaggio@columbia.edu);

Kermani: UC Berkeley (email: kermani@berkeley.edu); Ramcharan: Federal Reserve Board (email: rodney.ramcharan@frb.gov). Supplemental material can be found here.

1 Introduction Six years after the …nancial crisis, many households remain debt-burdened and unemployment remains elevated despite highly expansionary monetary policy. Perhaps unsurprisingly, the e¤ectiveness and appropriateness of monetary policy after the …nancial crisis is a subject of vigorous debate. This paper adds to our understanding of the impacts of monetary policy by providing household-level evidence on the e¤ect of interest rates on household consumption and saving decisions. In doing so we assess the extent to which household deleveraging and mortgage contract rigidities dampened the e¤ectiveness of monetary policy.

The conventional wisdom is that monetary policy a¤ects …rms’ investment and households’ consumption by reducing the cost of external …nance. However, contractual frictions might limit the extent to which changes in monetary policy actually a¤ect the cost of …nance for households and …rms. When the terms of debt contracts are rigid, as in the case of most …xed-rate mortgage contracts, changes in interest rates have little direct e¤ect on consumption and investment decisions for already indebted households: only potential new borrowers or those able to re…nance their mortgages will be a¤ected. In fact, during recent years banks were unwilling to re…nance mortgages on “underwater” homes that were worth less than the amount still owed on them.1 This can limit the pass-through of lower interest rates to households, and therefore the ability of expansionary monetary policy to stimulate households’consumption.

If borrowers’ marginal propensity to consume is greater than that of lenders, a decline in interest rates results in a positive income shock that should increase consumption, to an extent that depends on the magnitude and the persistence of its e¤ect (i.e. the period of time in which monthly payments are likely to remain at lower levels), and boost economic activity.2 However, this consumption response can be dampened by an increase in precautionary saving, which we call “voluntary deleveraging” 3 We provide micro evidence of both e¤ects.

.

Programs like the Home A¤ordable Re…nance Program that removed loan-to-value requirements for the re…nancing of loans insured by GSEs were implemented speci…cally to pass on the bene…ts of the new monetary policy regime to households.

See, for instance, Carroll et al. (2014) for evidence supporting the hypothesis that the MPC is correlated with wealth; and Mian and Su… (2012b) for evidence on the importance of this aggregate demand channel and its role in explaining the increase of unemployment in the U.S. during the Great Recession.

A similar mechanism is proposed by Guerrieri and Lorenzoni (2011), who study the e¤ects of a credit crunch on consumer spending and show that after an unexpected permanent tightening of consumers’ borrowing capacity, the most indebted consumers tend to readjust towards lower levels of debt. Relatedly, Carroll (2009) show that if consumers are subject to transitory as well as permanent shocks, a positive shock to permanent income might Isolating borrowers’consumption and saving responses to a change in interest rates is di¢ cult

–  –  –





nances and creditworthiness. For instance, households with a bad credit history may be unable to re…nance; the same may apply to liquidity-constrained households, which cannot pay the closing costs of their pre-existing mortgage.4 Similarly, households living in counties where the housing market has experienced a more severe crash are less likely to have enough equity to be able to re…nance, muting their consumption response to the drop in interest rates.

To overcome this identi…cation challenge, we exploit the anticipated changes in monthly payments of borrowers with adjustable rate mortgages (ARMs) originated between 2005 and 2007, with a …xed interest rate for the …rst 5 years, which is automatically adjusted at the end of this initial period. These cohorts experience a sudden and substantial drop in the interest rates they pay upon reset, regardless of their …nancial position or credit worthiness and without re…nancing.

These cohorts are of particular interest because the interest rate reduction they experienced is sizeable: the ARMs originated in 2005 bene…ted from an average reduction of 3 percentage points in the reference interest rate in 2010.

The key to our identi…cation strategy is the ability to exploit the timing of the interest rate adjustment. E¤ectively, we compare borrowers who will experience the interest rate adjustment at di¤erent points in time. This allows us to control for the endogeneity of the re…nancing decision and to focus on the e¤ects of the cut in monthly payments on their consumption behavior. To implement this strategy, we merge households’mortgage data with their credit reports (provided by Equifax), which allows us to observe the balance of all their liabilities, such as credit cards and auto loans, and other revolving or installment debts. To investigate whether the interest rate adjustment resulted in faster deleveraging, we analyze data on the households’repayment behavior for both installment and revolving loans. Furthermore, by restricting attention to households with this type of mortgage, we limit potential concerns about the households’characteristics driving the choice between …xed-rate and adjustable-rate mortgages.5 temporarily boosting saving.

For instance, Agarwal et al. (2013) point out that the incentives might depend on the size of the mortgage, as they estimate the spread between the current and the re…nancing interest rate that justi…es re…nancing at 1.1 to 1.4 percentage points for mortgages between $100,000 and $200,000. Campbell (2006) discusses these issues in greater detail.

Campbell and Cocco (2003) show that unconstrained households prefer ARMs when in‡ ation risk is large relative to real interest rate risk, while credit-constrained households might opt for them when they have low risk aversion;

We …rst document the e¤ect of interest rate resets on monthly payments for households with 5-year ARMs and show that the monthly payment fell on average by $900 (52 percent) upon reset.

The payments tend to stay constant before the reset month, as well as afterwards, suggesting that indeed the monthly payments featured a signi…cant, permanent step decrease as a function of the interest rate. We control for borrowers’characteristics as well as county-time …xed e¤ects, which capture any unobserved time-varying variation at the county level, and allow for di¤erent trends for each di¤erent origination cohort. Exploiting this sharp change in monthly payments, we document three main …ndings.

First, we …nd a positive consumption response to a drop in monthly payments. We measure consumption in two di¤erent ways. First, we identify the instances in which households purchase a car by applying for an auto loan, which constitutes our main measure of consumption of durable goods. Second, we employ information from bank credit cards as well as revolving store credit cards, as a measure of other forms of consumption, such as purchases at chains like Best Buy or Macy’ Using both measures, we show that the households that experience a drop in monthly s.

mortgage payments increase their consumption of durables on average by $150 per month (or 40%), controlling for household and time …xed e¤ects in the quarter after the change. Since the change in the mortgage payments is anticipated, we observe a slight but statistically signi…cant increase in the quarter before the change, but the households’ consumption expenses spike in the quarter after the reset and remain signi…cantly higher for two years. This result is robust to controlling for county-time …xed e¤ects, as well as allowing for heterogeneous trends for each origination cohort and for di¤erent mortgage sizes. In other words, a borrower with a mortgage resetting in January 2010 (after interest rates were reduced) will consume signi…cantly more in the …rst quarter of 2010 than a borrower with a reset at a di¤erent point in time, say June 2010. The amount spent on durable goods, and also the probability of purchasing a new car, spikes after the reduction in the interest rate. Similar results are obtained with our second measure of consumption derived from retail credit cards.

We then turn to the analysis of voluntary deleveraging. We observe all the payments made towards mortgages and all the other debts, e.g. equity loans and home equity line of credit. We show that households use more than 10% of the increase in disposable income to repay their debts however, they are unattractive to risk-averse credit-constrained households with a high debt-to-income ratio.

faster. This amounts to a doubling of their expenditures on debt service. Although our …rst result suggests that low interest rates boosted consumption, this second result suggests that this e¤ect was attenuated by the high level of debt accumulated during the boom years and a desire to deleverage.

We complement these results by analyzing the behavior of borrowers with di¤erent loan-tovalue ratios (LTV) and show that there is a signi…cant di¤erence in their consumption behavior.

Speci…cally, borrowers with an LTV above 120% a year before the reset invest less in deleveraging.

But interestingly high-LTV households’consumption is almost twice as much as other borrowers.

This can be for two di¤erent reasons. First, because they are deleveraging less, they might have more resources available to consume. Second, as shown by Zeldes (1989a) and Aiyagari (1994), the

–  –  –

But interestingly borrowers with lower LTV are those that invest more in deleveraging. This con…rms the intuition that the borrowers with low or intermediate LTV ratios, who are closest to building equity in their homes, are more likely to delever than deeply underwater homeowners. We also …nd that low-income households tend to consume signi…cantly more and deleverage less than high-income ones.7 Finally, we investigate the implications of our …ndings for the aggregate economy. To estimate the e¤ect of monetary policy on county-level aggregate consumption, we exploit the geographical variation in the presence of adjustable-rate mortgages: ARMs have been more popular in some parts of the U.S. than others due to di¤erent housing costs. Speci…cally, counties in California and Florida –and in general in coastal areas –have had higher levels of ARM origination. Using data from Lender Processing Services (LPS), on the fraction of ARMs originated at the county level, we construct a measure of how much each region is directly exposed to changes in monetary policy.

First, we show that the fraction of outstanding ARMs as of 2006 is highly predictive of the monetary policy interest rate pass-through in 2007-13. In other words, the average mortgage rate in regions with a higher fraction of ARMs reacts more to the decline in interest rates. Then, by looking at quarterly car sales between 2007 and 2013, we show that changes in the interest rates tend to have a disproportionately larger e¤ect on car sales in counties with a greater fraction of It is also possible that households that experienced a more severe wealth shock during the recession have reduced more their consumption and therefore it is a longer time since they purchased a car (see Eberly (1994) and Berger and Vavra (2014)).

Evidence of …nancing constraints at the household level has been widely documented by, among others, Zeldes (1989a), Jappelli and Pagano (1989), Campbell and Mankiw (1989), and Carroll and Dunn (1997).



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