Household Debt, Adjustable-Rate Mortgages, and the Shock-Absorbing Capacity of Monetary Policy

Theory predicts that the adverse effects of increases in the risk-free rate on homeowners’ default rates would be significantly stronger if interest rates paid on mortgages were variable and initial household debt burden were higher. Given the direct negative relationship between these default rates and banks’ capital, this prediction represents a necessary ingredient for a novel financial intermediary capital based mechanism by which monetary policy can dampen the macroeconomic effects of expansionary demand shocks. Using a flexible non-linear reduced form identification approach, this paper sheds important light on the relevance of this mechanism by estimating the U.S. economy’s responses to expansionary credit supply shocks conditioned on a state in which both the adjustable-rate mortgage market share and household debt burden are high. The evidence conclusively suggests that being in the latter state greatly increases the capability of monetary policy to dampen the effects of an expansionary credit supply shock, and that the prevalence of a financial intermediary capital channel underlying these results is borne out by the data.