Discussion of “Inflation Experiences and

Contract Choice – Evidence from Residential Mortgages”

by Matthew J. Botsch and Ulrike Malmendier

NBER SI 2015 Household Finance MeetingJuly 17 2015

Jonathan A. ParkerMIT Sloan finance

1. The main idea

• Households who place greater subjective probability on the possibility of high inflation are more likely to choose fixed rate mortgages

• Would like to run binary-outcome regression:

or

• Note: πExperienced varies only by cohort and year• Potential problem: covariates (next slide)

2. The estimation methodology

Want to control for household characteristics that• are correlated with πExperienced • and drive mortgage choicePrime possibilities:• Wealth• Income• LTV• FICOOnly observe very few household characteristicsBut observe interest rate and characteristics of chosen mortgage

Examples

• FICO varies with age and reflected in interest rate on mortgage options and so influence mortgage choice correlated with πExperienced

• Nonconforming varies with age and influence mortgage choices in a way correlated with πExperienced

• So . . .

• Ideally, run the binary choice model based on

• But the rate is not observed for the unchosen option, so run a selection of FMR/ARM model to estimate the rates as a function of observables with the un-observables correlated with the error term in the rate equations. Selection equation:

• Construct FRM and ARM fitted rates & estimate

1. WTP: 0.211/0.424 = 0.498 percentage points more for an FRM per 1% of higher πExperienced

- Odd identification of WTP for a macro person: the term structure represents the price of dollars today vs. dollars in the future, or different default risks and term structure of default risk, not different cost of mortgage

2. What would happen if people did not pay attention to past inflation?• Paper: set =0 in utility of choice

equation (each containing ). Exaggerates effect.

• I would prefer:• πExperienced = US historical average π• Or post-Fed average π, or post-“LR PC is vertical”

average π, or post-ratex revolution average π• πExperienced = Advanced-economy historical average π• Market expectations from inflation swaps• Model-based forward-looking expectations (for a

country with massive debt and unfunded liabilities)

• “Partial-equilibrium” change

3. Further comments/suggestions

1. Welfare: – Come up with a method & process for

inflation that implies optimal choices for households for whom the observed range of inflation expectations are not pivotal. Then calculate welfare. Will be much smaller.

– Or be agnostic about the correct choice• Federal credit subsidies are effectively larger for

FRMs

– Big (recent) debate over what the optimal contract is

3. Further comments/suggestions

2. Corroborating evidence– Look at variance of inflation experience• You are looking at the choice of options

– Look at nominal interest rate experience• Why inflation not nominal interest rates?

– Look at house price experience• Lots of other experiences are correlated

with cohort and age – stock market, bond market, GDP growth• House prices have variation across

region/people

3. Further comments/suggestions

3. Explicitly think about rejecting alternative theories– Inattention?– Optimism

IV. Conclusion• This paper provides evidence that is

consistent with a body of work on the importance of experience for expectations, and inflation expectations in particular and then for these affecting real decisions – Not a smoking gun– But part of a growing body of evidence

• Higher past inflation experience leads to a higher WTP for bet that pays off when inflation high

• I am not sure yet whether this effect is big or small. Looks small to me.