Wages, inflation, and mortgage design

By virtue of creating asset-liability mismatch, conventional long-term, fixed-rate mortgage loans inherently introduce excess interest risk to the financial systems. Considering that inflation is in part the reason for this excess interest risk, it seems natural to redesign mortgages in such a way that over time mortgage payments could, at least in part, reflect inflation. In this paper, I show that by allowing payments to adjust to inflation, particularly that of wages, by incorporating a prespecified growth rate into mortgage payments, mortgage loans become more affordable while bank interest spreads become less volatile, making the banking system less unstable. (C) 2010 Elsevier Inc. All rights reserved.