Formula to calculate loan repayments

The move from a regime of high inflation to one of price stability can have
consequences which again are best illustrated by the housing market. A credible
move to inflation targeting can bring down inflation expectations relatively quickly,
even if with a lag. Chart 7 shows that inflation expectations, as measured by surveys,
fell steadily following the introduction of inflation targeting, and are now anchored on
the 2.5% target. But a move to low inflation has other consequences that may be less
easily understood.

Price stability means lower nominal interest rates, and lower
mortgage interest payments. It may also mean lower real interest rates if the inflation
risk premium falls. But the fall in nominal rates is likely to be much larger than the
fall in real rates. The lower mortgage payment largely reflects a rise in the effective
duration of the loan because inflation no longer erodes the real value of the debt as
quickly as before. In a low inflation world, nominal incomes rise more slowly than
before and the real burden of servicing the debt persists. It may take longer for
households to work out the impact of low inflation on real interest rates than to realise
that the rate of increase of prices of everyday purchases has fallen. Learning takes
time.

One possible consequence of a slow adjustment to low inflation is that households
may mistake too much of the reduction in nominal interest rates for a permanent fall
in the real rate. As a result, asset prices are bid up to levels that prove unsustainable
when learning finally occurs – and at the LSE you know that in time we do learn.

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