High public debt raises interest rates needed for price stability
High public debt raises the interest rate needed to keep inflation on target, according to a European Central Bank (ECB) research article. Central banks retain control by responding directly to debt increases rather than waiting for inflation.
Debt changes the policy prescription
Stéphane Dupraz of Banque de France and Anna Rogantini Picco of the ECB find that public debt raises demand when households spend debt-financed transfers rather than save everything for future taxes.
Higher rates normally counter this pressure.
But responding only to inflation can increase future debt and prolong inflation; stronger tightening may barely reduce cumulative inflation or even increase it.
Their model instead prescribes responding directly to higher debt to track the natural interest rate.
Their main estimate places the debt limit beyond which monetary control fails at about 5.4 times annual GDP, far above current advanced-economy ratios.
The article expresses the authors' views, not necessarily those of the ECB or Eurosystem.
Household spending breaks the equivalence
US households spent 8-11 percent of their 2008 tax rebates on non-durable goods in the quarter of receipt, according to Borusyak, Jaravel and Spiess (2024).
This challenges the assumption that households save all transfers for future taxes.
US estimates put the long-term interest rate increase at about 3 basis points per 1 percentage point rise in debt-to-GDP.
The Maastricht Treaty set deficit and debt limits of 3 percent and 60 percent of GDP.
Green transition and defence spending now add financing needs.
Track debt before inflation
The authors distinguish debt monitoring from conducting fiscal policy.
In their framework, higher debt raises the natural interest rate, requiring a monetary response before inflation increases.
They acknowledge that reacting to fiscal decisions can be institutionally uncomfortable.
Source: Monetary policy in times of high public debt
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