Is high debt constraining monetary policy? Evidence from inflation expectations

Summary

Focus

With the Covid-19 crisis, sovereign debt levels around the world rose to new heights. Debt levels are expected to remain high in the coming years, and demands on fiscal policy remain substantial. At the same time, higher levels of interest rates may increase debt service considerably.

Does higher debt make it more difficult to contain inflation? In principle, various mechanisms through which this could be the case are conceivable. For example, monetary policymakers may be (seen as) hesitant to raise interest rates as much as needed to reduce inflation because this boosts borrowing costs for governments. Central banks may also worry about the impact of rising rates on their own net income if they pay banks interest on excess reserves. Moreover, bonds previously bought by central banks drop in value when interest rates rise, which means that central banks may avoid raising rates and thereby losses. In extreme cases, people may even believe that the central bank could try to inflate away part of the debt or "print money" to pay for future deficits.

Contribution

This paper assesses the impact of debt on inflation expectations. Inflation expectations are an important driver of actual inflation. The higher inflation expectations are, the more difficult it is for central banks to bring inflation downs. Specifically, the paper examines the impact of sovereign debt surprises (ie unanticipated changes in debt) on inflation expectations in advanced and emerging market economies.

Findings

The paper finds that debt surprises raise long-term inflation expectations in emerging market economies in a persistent way, but not in advanced economies. The effects are stronger when initial debt levels are already high, when inflation levels are initially elevated, and when sovereign debt is denominated to a significant extent in dollars. By contrast, debt surprises have only modest effects in countries with inflation targeting regimes. Increased debt levels may complicate the fight against inflation in emerging market economies with high and dollarised debt levels, and weaker monetary policy frameworks.

Abstract

This paper examines whether high public debt levels pose a challenge to containing inflation. It does so by assessing the impact of public debt surprises on inflation expectations in advanced and Emerging Market Economies. It finds that debt surprises raise long-term inflation expectations in Emerging Market Economies in a persistent way, but not in advanced economies. The effects are stronger when initial debt levels are already high, when inflation levels are initially high, and when debt dollarization is significant. By contrast, debt surprises have only modest effects in countries with inflation targeting regimes. Increased debt levels may complicate the fight against inflation in Emerging Market Economies with high and dollarized debt levels, and weaker monetary policy frameworks.

JEL classification: E31, E41, E52, E62

Keywords : inflation expectations, monetary policy, fiscal dominance, debt