Public debt alters monetary policy transmission in Europe
A new Bank for International Settlements (BIS) working paper examines how public debt levels and maturity structure influence monetary policy transmission in advanced and emerging Europe. It finds that higher public debt is associated with a weaker response of prices and inflation expectations to tighter monetary policy.
Debt levels reshape policy impact
The paper, using high-frequency euro area monetary policy shocks and panel local projections for 2001-2020, reveals that public debt significantly influences monetary policy transmission.
Higher public debt is linked to a weaker response of prices and inflation expectations when monetary policy tightens.
Output, however, declines at least as much as in low-debt economies.
The maturity structure also plays a non-linear role: debt at intermediate maturities shows weaker effects, while very short and long maturities are associated with stronger effects.
This suggests that fiscal backing is often incomplete, as primary balances tend to deteriorate following monetary tightening, preventing full neutralisation of monetary policy effects on government balance sheets.
Three channels, varied effects
The study identifies three key channels: fiscal risk repricing, valuation effects, and interest income effects.
Fiscal risk repricing can amplify financial tightening, while valuation effects from bond losses reinforce contractionary impacts.
Conversely, higher interest income for bondholders can attenuate contractionary effects.
The quantitative importance of these channels depends on the debt level and its maturity profile.
Shorter maturities accelerate policy rate pass-through, strengthening the income channel.
Longer maturities, however, amplify valuation effects due to higher bond price sensitivity, creating a complex interplay.
Beyond standard assumptions
This paper empirically confirms the significant role of public debt in monetary policy transmission, a factor often overlooked in standard models.
Its detailed analysis of maturity profiles and cross-country spillovers provides valuable insights for policymakers.
However, the study's reliance on historical data up to 2020 might limit its applicability to the post-pandemic debt landscape.