Mortgage refinancing and equity extraction (cash out- refinancing) were at epicenter of the financial crisis. A decade later, the rapid expansion of FinTech has substantially lowered the costs of refinancing making it more attractive for borrowers to refinance. What are the implications of these changes for the efficacy of monetary policy? In the paper “State Dependent Effects of Monetary Policy: The Refinancing Channel,” JRCCPPF’s faculty affiliate Arlene Wong and co-authors Martin Eichenbaum and Sergio Rebelo, find that lower refinancing costs is good news for the Federal Reserve “…as refinancing costs decline, monetary policy becomes more powerful.”
Recent studies have stressed the importance of mortgage refinancing as a key channel through which monetary policy affects the economy but the focus has been on the ability of the households to refinance. These constrains were certainly very important in the aftermath of the financial crisis. But Wong and co-authors point out that in the run-up to the crisis it was demand-side factors, households’ desire for refinancing, that were very important and these will become increasingly important as credit markets return to normal.
In the U.S. most mortgages have fixed interest rate and no prepayment penalties, so households’ demand for refinancing depends on the potential savings that a household stand to gain. These in turn depend on many factors, such as the old and new mortgage interest rates, outstanding balances as well as on the fixed costs of refinancing. At any moment in time there is a distribution of the potential pool of savings from refinancing. Wong and co-authors develop a quantitative dynamic life-cycle model and find that the efficacy of monetary policy varies in a systematic way with the variations in this pool.
Distribution of potential savings in 1997q4 and 2000q4
The model implies that the effect of a given interest rate cut depends on the history of monetary policy choices. An interest rate cut is less powerful when preceded by a series of interest rate hikes and more powerful when preceded by a series of interest rate cuts. When interest rates have been falling, many borrowers have fixed mortgages that are higher than the current market rate and will be motivated to refinance in response to an interest rate cut, not so when interest rate have been rising. As refinancing costs decline, refinancing rates increase and the distribution of savings from refinancing vary less over time and become concentrated around zero. So, the effects of monetary policy depend less on the history of interest rate changes.
As refinancing costs fall, monetary policy becomes more powerful. The intuition is that more people refinance in response to an interest rate cut and many people are already against their borrowing constraint. These people engage in cash-out refinancing to boost their consumption. So, the rise of Fintech is expected to result in a strengthening of the refinancing monetary channel in the U.S. Read More...