High public debt constrains monetary policy, fuels inflation

A new BIS working paper reveals that elevated public debt sharply increases the fiscal cost of fighting inflation, potentially dampening monetary responses. This interaction can generate an inflationary bias and amplify price pressures, even with fiscally backed government debt.

Fiscal limits on rate hikes

The study formalizes a mechanism where high public debt creates a state-dependent fiscal constraint on monetary policy.

As interest rates rise, government interest expenditures increase significantly, pushing the debt-to-output ratio towards its fiscal limit.

This forces central banks to moderate or forgo planned monetary tightening to avoid severe costs, including political backlash from fiscal authorities.

Consequently, monetary policy, while remaining active, may exhibit a weaker resolve in fighting inflation than prescribed by standard rules.

This leads to an inherent inflationary bias, even when fiscal policy remains disciplined and public debt is fully backed by future primary surpluses.

The model's nonlinear structure is crucial for capturing how the proximity to this fiscal limit endogenously constrains policy, a nuance lost in linearized frameworks.

This dynamic differs from the Fiscal Theory of the Price Level, as inflation here stems from anticipated central bank moderation rather than fiscal policy failure to stabilize debt.

Debt levels blur policy boundaries

Globally, rising public debt is blurring traditional boundaries between monetary and fiscal authorities.

Examples like the nearly one trillion dollars in net interest outlays on U.S. federal debt in fiscal year 2024–2025 highlight how monetary policy decisions now significantly impact fiscal space.

This context intensifies pressures on central banks to limit interest rate hikes, as seen during the Trump administration's calls for lower rates.

The paper's model introduces an endogenous fiscal constraint as an upper bound on the policy interest rate, which varies with macroeconomic conditions.

Higher inflation or strong output growth can relax this constraint, while low inflation, weak growth, or high initial debt tighten it.

This feedback loop means monetary policy affects fiscal space directly through interest rates and indirectly through its impact on inflation and output, creating a complex, state-dependent interaction.

A reverse zero lower bound

This fiscal constraint acts as a reverse zero lower bound, limiting how far rates can be raised in high-debt environments, much like the ZLB limits rate cuts in low-inflation periods.

Both constraints are state-dependent and generate persistent macroeconomic biases, with the fiscal limit inducing an inflationary bias.

In extreme demand-driven downturns, this fiscal constraint can become even more restrictive than the ZLB, forcing central banks into stark trade-offs: either large-scale asset purchases or accepting fiscal dominance.

This analysis is crucial for understanding the limits of monetary policy in today's high-debt advanced economies, where even independent central banks may accommodate inflation to preserve fiscal and financial stability.