Public debt and monetary policy transmission: evidence from advanced and emerging Europe
Summary
Focus
In standard models of monetary policy, public debt is assumed to have no role. Policy rate changes affect output and inflation through conventional channels, and any fiscal consequences of interest rate changes are assumed to be offset by corresponding adjustments in fiscal policy. However, with public debt high in many economies, this assumption may no longer be innocuous. Changes in monetary policy affect not only private borrowing costs but also government interest payments, the income earned by government bondholders and the market value of outstanding public debt. The impact depends on the size of the debt stock, which magnifies these effects, and the maturity profile, which determines how quickly higher policy rates pass through to debt service costs and interest income. It also depends on the sensitivity of bond values to changes in yields.
Contribution
We provide new empirical evidence on how the size and maturity profile of public debt interact with monetary policy in the euro area. We also construct new data for central and eastern Europe and examine how spillovers from euro area monetary policy depend on the public debt level and maturity in advanced and emerging European economies outside the euro area.
Findings
The empirical evidence indicates that high levels of public debt weaken the response of inflation and inflation expectations to tighter monetary policy, while output falls at least as much as in low-debt economies. The evidence also points to a non-linear relationship between debt maturity and monetary transmission. Debt at intermediate maturities is associated with smaller responses of output and prices to monetary policy shocks. By contrast, debt at very short and long maturities is associated with larger responses. These results are consistent with the interaction of the channels mentioned above: very short maturities make fiscal balances and refinancing needs more sensitive to policy rates, intermediate maturities may allow interest income effects to partly offset valuation effects, and longer maturities strengthen valuation effects. Our results also suggest that international spillovers of monetary policy depend on the debt maturity structure in the receiving economy.
Abstract
Using high-frequency euro area monetary policy shocks and panel local projections for the period 2001-2020, this paper examines how macroeconomic variables respond based on the level and the maturity structure of public debt. The results show that public debt plays a significant role in influencing monetary policy transmission. Higher public debt is associated with a weaker response of prices and inflation expectations to tighter monetary policy, while output declines at least as much as in low-debt economies. The maturity structure of debt also matters in a non-linear way: debt at intermediate maturities is associated with weaker effects, whereas debt at very short and long maturities is associated with stronger effects. Fiscal responses indicate a lack of contemporaneous fiscal backing, as primary balances tend to deteriorate following monetary tightening. Finally, for non-euro area European economies, the paper introduces a novel dataset on public debt maturity profiles and shows that spillovers from euro area monetary policy depend on the maturity structure in the receiving economy.
JEL Codes: E31; E52; E62; E63
Keywords: monetary policy transmission, government debt, debt maturity, policy spillovers
