Government debt changes the impact of monetary policy

To fight inflation, the ECB and other central banks hiked interest rates. Clearly, this should reduce economic growth as financing costs increase for businesses and households. But they also increase for the biggest borrower of all, the government. And that, in turn, may influence the economy again.

Think about it this way. If a country has a higher debt-to-GDP ratio, an interest rate hike by the central bank will increase the cost of borrowing for the government. And that means that either the deficit increases or the government has to cut spending in other areas to keep the deficit constant. If the government chooses to let the deficit increase, investors may expect future inflation to be higher to inflate this excess debt away. If the government cuts spending, investors may expect lower GDP growth going forward.

And this is roughly what a study by the Bank for International Settlements (BIS) found. The chart below shows the reaction of European countries to a monetary policy shock from the ECB. The two countries are stylised to debt-to-GDP-levels of 60% and 120%.

Response of high- and low-debt country to a monetary policy shock

In the case of the low-debt country, a one standard deviation increase in policy rates (in the case of the ECB, that is about 50bps) reduces GDP by about 1.75% after one year. In the case of the high-debt country, the damage is about 2.25% after three quarters because the higher interest rates take out a bigger chunk of the budget as maturing debt needs to be replaced.

Meanwhile, the price effect is larger for the low-debt country than the high-debt country. To deal with the higher debt that is now rising faster because of higher interest rates, the government is more likely to let inflation run high. And this, in turn, changes the expectation of future inflation of businesses and households and thus influences actual prices.

Take these two findings together, and you can see that in a low-debt country, monetary policy is more effective than in a high-debt country. Or turn it around and realise that in a high-debt country the central bank has to hike and cut interest rates more aggressively to get the same economic effect as in a low-debt country. And today, most developed countries are high-debt countries, which means that monetary policy has become less effective and interest rate volatility may need to rise in the future.

But there is more. The study also looked at the reaction of GDP and prices to changes in different maturity buckets. And this turns out to be U-shaped. If the central bank hikes rates, the yields in bond markets rise as well. Rising yields in shorter maturity bonds and money markets have a larger impact on output and inflation than rising yields in longer maturity bonds (no surprise there). But go out to even longer maturities (longer than 8 years) and the impact of a monetary policy shock increases again.

Countries that rely heavily on extremely long duration bond issuance like the UK suffer more when the central bank hikes rates than countries like France, which mainly issue bonds in the intermediate maturity range – even though these two countries have similar levels of debt-to-GDP. The reason for this divergence is that if a long bond matures, it is typically replaced by issuing another bond with a long maturity. But if interest rates are higher, the government locks in these higher interest costs for a longer time and thus does more damage to its finances than a country that borrows at shorter maturities.

Response of different bond maturities to a monetary policy shock

These results are bad news for the US and the UK. For the US because it is increasingly indebted with persistent excessive deficits. Thus, monetary policy has become less effective in the US and reduces inflation less than it used to. In the UK, this is because the country is heavily indebted and borrows at longer maturities than other developed nations. While the deficit is more manageable, the high debt levels and longer maturity profile reduce the effectiveness of the Bank of England’s monetary policy and force the Bank to be more aggressive in rate hikes and cuts going forward to get the same economic effect.