Effects of High Inflation and Tight Monetary Policy on Public Debt

Zolto Darvas

Rising inflation has triggered monetary tightening in some countries, and the resulting rise in interest rates has raised concerns about the sustainability of public debt in countries with high public debt. An economic slowdown triggered by Russia’s invasion of Ukraine could exacerbate these concerns. In this context, it may seem puzzling that the European Commission and the International Monetary Fund have lowered their public debt ratio forecasts for most countries. In particular, the IMF announced in April 2022 that his April 2021 public debt ratios in all of his EU member states except Germany, Malta, the Netherlands and Romania, his April 2021 We have revised down our long-term forecast from The IMF also lowered its forecasts for the UK and US debt ratios, but raised those for Japan.

This blog post focuses on the IMF’s 2026 debt ratio projections for 16 countries and examines why public debt ratio projections have been revised. Using accounting equivalence and the “everything else unchanged” assumption, my main conclusion is that only a rise in interest rates and real GDP growth will result in a relatively modest public debt ratio in 2026. However, inflation will significantly reduce the debt ratio. .

In our calculations, an inflation shock affects the public debt ratio through three channels. Higher nominal GDP will increase tax revenues, leading to lower budget deficits and public debt. Less debt means less interest payments, less borrowing and less debt. Higher nominal GDP lowers this ratio. Similar calculations were made for the revenue-to-GDP ratio, primary expenditure, the so-called stock flow adjustment.

Interest rates and inflation shocks are interrelated, as inflation shocks are the main driver of central bank interest rate hikes. This interrelationship is taken into account in IMF projections. Inflation shocks also reduce the real value of public spending, which governments may later make up for. My calculations therefore do not capture the overall impact of an inflation shock, but do calculate how much interest rates, inflation, and other factors contributed to the revision of his IMF debt ratio forecast for 2026. can.

Interest rate and growth differentials are important determinants of public debt sustainability. If interest rates are higher than growth, the government will need to maintain a basic budget surplus to prevent an explosion in the debt-to-GDP ratio. But if interest rates fall below growth, debt ratios can fall even without a primary surplus.

The average interest rate paid by the government in a year is the average of the coupon rates of all outstanding bonds and reflects historical borrowing costs. Most government bonds are fixed rate bonds. Governments borrow to finance deficits and to refinance maturing bonds and bills. Higher interest rates therefore immediately increase the cost of new borrowing.

The interest cost of outstanding bonds remains unchanged. Therefore, the average interest rate on outstanding debt does not change in tandem with changes in current interest rates.

In Italy, average interest rates were above nominal growth from 1990 to 2020. Since then, the two variables have been broadly similar or growing faster than interest rates.

The IMF’s debt ratio forecasts have been revised significantly downwards in Italy and the US, but have risen in Germany and Japan. This may seem counterintuitive as Italy has higher interest rates than Germany and is rising faster.

Changes in the debt-to-GDP ratio include changes in interest rates, changes in the GDP deflator, changes in real GDP development, changes in tax rates measured as the ratio of income to GDP, changes in major (non-interest) expenditures, changes in stock There are 6 possible elements. – Flow adjustment changes as the difference between net borrowing and change in debt. For each of these factors, we consider the impact of changes between his WEO 2021-2026 in April 2021 and April 2022 by keeping the other variables at their April 2021 values. There are interactions between the factors, so the sum of the six factors does not add up to the total change in debt ratio. That’s why we also include a category for “other changes”.

The impact of unexpected interest rate changes was positive for 12 countries, with the UK (7.3 points of GDP), the US (5.9), Poland (5.5) and the Czech Republic (3.0) being the most affected. The interest rate impact is only 1.0 for Italy, 0.5 for Germany, and minus 0.6 for Japan (this means that the expected interest rate in Japan fell from April 2021 to April 2022 forecast ).

The impact of interest rates is mitigated by the impact of unexpected inflation. This is expected to reduce the UK and US debt ratios by more than 20 percentage points of GDP, and Italy and Germany by about 12 percentage points. A shocking 35% drop in unexpected inflation is expected in Poland, the largest drop in the forecast for the GDP deflator as a result of the sharply revised outlook. April 2021 WEO shows Poland’s GDP deflator 2020-2026, April 22 his WEO forecasts a 41% increase over the same period. Of the 16 countries, only Ireland (1.7 points) and Japan (7.8 points) saw their debt ratios rise due to unexpected changes in inflation rates, reflecting the lower inflation outlook in these two countries. increase.

The impact of revisions to real growth forecasts will reduce debt ratios in three-quarters of countries, but generally only slightly, with the exception of Ireland and Slovenia. In Ireland, real GDP projections have been revised significantly upwards. Revised real GDP forecasts for 2020-2026 are expected to increase public debt ratios in 5 out of 16 countries (Czech Republic, France, Germany, Romania and Japan).

The impact of tax rate changes has been mixed, with half of the countries having higher debt ratios and the other half having lower debt ratios.No clear pattern in stock flow modification

adjustment? The biggest revision to the stock flow adjustment was in the UK, where the debt ratio fell by 15 percentage points of GDP.

Combined, these factors lead to a significant reduction in the ratio of public debt to GDP. But even in the face of a major inflation shock, non-interest public spending cannot be sustained. Certain spending may be indexed to inflation, like pensions, but unexpected inflation reduces the real value of public spending. This means that fewer goods and services can be purchased for the same amount of nominal spending. Governments may therefore tend to increase nominal spending. Especially since higher inflation will lead to a significant increase in tax revenue.

Moreover, Russia’s attack on Ukraine has caused many countries to spend more on defense and energy transition. Governments are also rushing to protect consumers from rising energy prices.The arrival of millions of Ukrainian refugees means huge financial costs for several Member States.

It is unclear to what extent WEO’s projections took into account this increase in non-interest spending. Nevertheless, increased spending is expected to increase debt ratios by an average of about 12% of GDP in all 16 countries analyzed.

In conclusion, an analysis of changes in the IMF’s 2026 public debt-to-GDP ratio projections for 2022 and 2021 suggests that the impact of monetary tightening and the deterioration of the economic outlook will be relatively small, while inflation will push the debt ratio significantly. suggested to decrease. Of course, since these calculations are based on IMF projections, they may underestimate the extent of monetary tightening (although they may also underestimate the rise in inflation). And if high interest rates persist for an extended period, the average interest cost of public debt could increase beyond 2026. Rising inflation could also increase long-term debt risk premiums, leave inflation expectations unfixed, and depress investment and growth. All these factors could undermine the debt sustainability of highly indebted countries. That said, at least for the next few years, higher government borrowing costs for new issues should be more than offset by the debt reduction impact of higher-than-expected inflation.


Zsolt Darvas is a Senior Fellow at Bruegel, a Brussels-based think tank. This was published as a post on his Bruegel blog, Cyprus Economic Association Blog. Effects of High Inflation and Tight Monetary Policy on Public Debt

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