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IsHighDebtConstrainingMonetaryPolicy?EvidencefromInflationExpectations

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MonetaryandCapitalMarketsandWesternHemisphereDepartments

IsHighDebtConstrainingMonetaryPolicy?EvidencefromInflationExpectations

PreparedbyLuisBrandao-Marques,MarcoCasiraghi,GastonGelos,OlamideHarrison,andGunes

Kamber*

AuthorizedfordistributionbyDavidHofman

June2023

IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate.TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement.

ABSTRACT:Thispaperexamineswhetherhighgovernmentdebtlevelsposeachallengetocontaininginflation.Itdoessobyassessingtheimpactofgovernmentdebtsurprisesoninflationexpectationsinadvanced-andemergingmarketeconomies.Itfindsthatdebtsurprisesraiselong-terminflationexpectationsinemergingmarketeconomiesinapersistentway,butnotinadvancedeconomies.Theeffectsarestrongerwheninitialdebtlevelsarealreadyhigh,wheninflationlevelsareinitiallyhigh,andwhendebtdollarizationissignificant.Bycontrast,debtsurpriseshaveonlymodesteffectsineconomieswithinflationtargetingregimes.Increaseddebtlevelsmaycomplicatethefightagainstinflationinemergingmarketeconomieswithhighanddollarizeddebtlevels,andweakermonetarypolicyframeworks.

RECOMMENDEDCITATION:

JELClassificationNumbers:

E31,E41,E52,E62

Keywords:

Inflationexpectations;monetarypolicy;fiscaldominance;debt

Author’sE-MailAddress:

lmarques@,mcasiraghi@,ggelos@,oharrison@;gkamber@

IMFWORKINGPAPERS

DebtSurprisesandInflationExpectations

INTERNATIONALMONETARYFUND3

WORKINGPAPERS

IsHighDebtConstrainingMonetaryPolicy?EvidencefromInflationExpectations

PreparedbyLuisBrandao-Marques,MarcoCasiraghi,GastonGelos,OlamideHarrison,andGunesKamber1

1TheauthorswouldliketothankGustavoAdler,BergljotBarkbu,DavidHofman,andErlendNierfortheircomments.ZoeStraussprovidedexcellentresearchassistance.

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DebtSurprisesandInflationExpectations

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Contents

INTRODUCTION 5

THEORETICALMECHANISMS 6

DATAANDEMPIRICALMETHODS 7

EconometricApproach 7

Data 10

RESULTS 12

MainResults–EmergingMarket-vs.AdvancedEconomies 12

StateDependence 15

GovernmentDebtLevel 15

InflationLevel 17

DebtDollarization 19

Inflation-Targeting 20

ROBUSTNESS 22

CONCLUSION 24

REFERENCES 25

FIGURES

1.DataAvailability_______________________________________________________________11

2.Debt-to-GDPSurprisesonImpact_________________________________________________11

3.DebtSurprisesAcrossWEOVintages______________________________________________12

4.Responseof5-YearInflationExpectationstoGovernmentDebtShocks,Baseline___________14

5.Responseof5-YearInflationExpectationstoGovernmentDebtShocks,byInitialDebt_______16

6.Responseof5-YearInflationExpectationstoGovernmentDebtShocks,byInitialInflationLevelClassification_________________________________________________________________18

7.Responseof5-YearInflationExpectationstoGovernmentDebtShocks,EmergingMarkets—InitialFXShareofGovernmentDebt_______________________________________________________20

8.ResponseofInflationExpectationstoGovernmentDebtShocks,byInflationTargetingRegimeClassification_________________________________________________________________21

9.ResponseofInflationExpectationstoGovernmentDebtSurprises,EmergingMarkets—ConditionalontheFiscalStance______________________________________________________________22

10.ResponseofInflationExpectationstoGovernmentDebtSurprises,Emerging______________23

TABLES

1.SummaryStatistics____________________________________________________________10

2.Responseof5-YearInflationExpectations,Baseline(FullSample)_______________________14

3.Responseof5-YearInflationExpectations,Baseline(EmergingMarkets)__________________14

4.Responseof5-YearInflationExpectations,Baseline(AdvancedEconomies)_______________15

5.Responseof5-YearInflationExpectations,byInitialDebtLevelClassification______________16

7.Responseof5-YearInflationExpectations,byInitialInflationLevel_______________________18

8.Responseof5-YearInflationExpectations,byInitialFXDebtShareClassification___________20

9.RegressionResults,byICRGFinancialRiskRating,EmergingMarkets___________________24

ANNEXES

ANNEXI__________________________________________________________________________________________

29

ANNEXII_________________________________________________________________________________________30

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Introduction

TheCOVID-19crisispropelledsovereigndebtlevelsaroundtheworldtonewheights.Between2019and2022,inadvancedeconomies,debtlevelsrosefrom103.9to112.5percentofGDP,andinemergingmarketeconomies,theygrewfrom55.1to64.6percentofGDP.Sovereigndebtlevelsareexpectedtoremainhighincomingyears(IMF,2022),anddemandsonfiscalpolicyremainsubstantial.Atthesametime,higherlevelsofinterestratescouldincreasedebtservicesconsiderablyinthecomingyears.

Couldtheriseingovernmentdebtlevelsposeaproblemformonetarypolicy?Thisquestionisofparticularrelevanceascentralbanksarestrugglingwiththemajorchallengeposedbyinflationarypressures.Inprinciple,variousmechanismsbywhichhighsovereigndebtlevelscancomplicatemonetarypolicymakingareconceivable.Centralbanksmaybe(seenas)hesitanttoraiseinterestratesasmuchasneededtoachievetheirinflationobjective,outofconcernfordebtsustainability.Theymayalsobeconcernedabouttheimpactofrisingratesontheirownnetincomeiftheyremunerateexcessreserves,andontheirbalancesheetsastheyproceedtoactivelyshrinkthem.Inanextremeformoffiscaldominance,peoplemaybelievethatthecentralbankcouldtrytoinflateawaypartofthedebtorresorttooutrightmonetizationoffuturedeficits,whichinturnwouldleadinflationexpectationstoshootup.Thefiscaltheoryofthepricelevelhasreformulatedthesenotions,arguingthatpricelevelsadjustsothattherealvalueofgovernmentdebtequalsthepresentvalueoftaxeslessspending(Cochrane2023).

Suchconcernsare,inprinciple,relevantforbothadvanced-andemergingmarketeconomies.Inmanyemergingmarketeconomies,theseissuesusedtobeverymuchattheforefrontuntiltheearly2000s.Forexample,Celasun,Gelos,andPrati(2004)foundthatfiscalvariableswereanimportantdeterminantofinflationexpectationsinmajoremergingmarketeconomies.Fiscalconsolidation,theadoptionofmorecrediblemacroeconomicandmonetaryframeworks,andthegrantingofautonomytocentralbankslessenedtheseconcernsintheseeconomiesoverthefollowingyears.However,centralbankcredibilityremainslessestablishedinsomeemergingmarketeconomies,whichasagrouparegenerallystillmorevulnerabletoexternalshocks.Althoughsovereignforeigncurrencyexposureshavefallen,currencymismatchesintheprivatesectorremainwidespread(BIS,2019),posingvulnerabilitiesthatultimatelycanthreatenthefiscalpositionoftheseeconomies.Becauseofthishistoricalbackgroundandthestructuralspecificitiesofemergingmarketeconomies,inthisstudywedifferentiatebetweenadvanced-andemergingmarketeconomies.

Severalotherstudieshaveempiricallyinvestigatedtherelationshipbetweenfiscalvariablesandinflationexpectationsinswithinflation-targetingcentralbanks(Catão&Terrones,2003;deMendonça&Machado,2013;Celasun,Gelos,andPrati,2004;Coibion,Gorodnichenko,andWeber,2021).Thesepapersfindgenerallythattighteningfiscalbalancesarehelpfulinreducinginflationexpectationsandobservedinflation,withstrongereffectsineconomieswithhighandpersistentinflation.Thispapertakesasomewhatdifferentapproachandcoversamuchlongerandrecentperiod.

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Specifically,weinvestigatehowsovereigndebtmayaffectinflationdynamicsbyexaminingitsimpactoninflationexpectations.Foridentificationpurposes,wefocusondebtsurprises.Wetraceouttheresponseofinflationexpectationstoanunexpectedincreaseinsovereigndebtusinglocalprojections.Sinceweareinterestedintheeffectsofdebtanddebtsustainability,toavoidcapturingdemand-sideeffectsrelatedtounexpectedfiscalexpansions,wefocusonlong-runexpectations(5yearsahead),undertheassumptionthatanyinflationaryeffectsofsuchdemandpressuresareshorter-lived.Tofurtherminimizedemandeffects(suchasinitialpricepressuresleadingtoade-anchoringofinflationexpectationsunrelatedtolonger-termdebtconcerns),wealsoconditiononexistingdebtlevels.

Wefindthatinresponsetodebtsurprises,inflationexpectationsinemergingmarketeconomiesrisesignificantly,whereastheydonotinadvancedeconomies.Specifically,foremergingmarketeconomies,a10-percentage-pointincreaseinthegovernment-debt-to-GDPratiotriggersastatisticallysignificant20-basispointincreaseinlong-terminflationexpectationswithinthefirstyearaftertheshockandreachingapeakof70-basispointwithinthesecondyear.Theeffectismuchlargerinemergingmarketeconomiesthatdonotfeatureinflationtargetingregimescomparedtothosethatdo,becausetheseregimesaretypicallyassociatedwithsoundmonetaryframeworksandautonomouscentralbanksthathelpcontainexpectationsoffiscaldominance.TheseresultsarebroadlyconsistentwithearlieronesofCatãoandTerrones(2005)whofindastrongpositiveassociationbetweendeficitsandinflationamonghigh-inflationanddevelopingcountries,butnotamonglow-inflationadvancedeconomies.

However,inlinewiththenotionthatdebtsustainabilityconcernsarebehindourresults,theeffectoninflationexpectationsisnotpresentforemergingmarketeconomieswithlowsovereigndebtlevels.ThesefindingsareinlinewiththosebyKwon,McFarlane,andRobinson(2009),whoreportevidenceconsistentwiththenotionthattheriskofadebt-inflationtrapissignificantinhighlyindebtedeconomies.

TheoreticalMechanisms

Weareprimarilyinterestedintheextenttowhichgovernmentdebtandconcernsregardingsolvencyofthesovereignmightaffectmonetarypolicyandtheabilityofacentralbanktoachieveitspricestabilityobjective.Alargetheoreticalliteratureestablishesdirectlinksbetweengovernmentdebtandthepricelevel.Thestartingpointisfiscaldominance:thatacentralbanktightensitsmonetarypolicystanceinresponsetoariseininflationbylessthanitwouldotherwisebecauseofthelevelofgovernmentdebt.

Totheextentthatthegovernmentdebtisinlocalcurrency,highgovernmentdebtmayleadcentralbankstolimitincreasesinthepolicyrateoutofconcernforthegovernment’ssolvency.Economicagents,inturn,anticipatethisreaction,raisingtheirinflationexpectations.Intheextreme,firmsandhouseholdsmayfearthatthecentralbankmayresorttooutrightdebtmonetization.Implicitinthesemechanismsisthatsomeportionofgovernmentdebtisnotbackedbythegovernment’scurrentand

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futureprimarysurpluses.TheseargumentsarewellestablishedbySargentandWallace(1981)andinsubsequentforward-lookingmodelsofinflation(AiyagariandGertler,1985;Calvo,1988;Bohn,1988,amongothers).AlthoughSargentandWallace(1981)neverdiscussthefiscalstanceordebtsustainability,thekeypointisthatthefiscalpathispredeterminedandneedstogenerateseigniorage.Acorollaryoftheseargumentsisthatatightermonetarypolicymaydeliverlowerinflationnow(andinextremecasesnoteventhat)butsurelyhigherinflationinthefutureiffiscalpolicydominatesmonetarypolicy.Thisisbecause(sufficiently)forward-lookingagentsanticipatetheneedforloosermonetarypolicylatertoinflateawaythepublicdebt.

AsimilarmechanismalbeitwithimportanttheoreticaldeparturesisdevelopedinthefiscaltheoryofthepricelevelorFTPL(Leeper1991,Sims1994,Woodford1994,Cochrane2005,andBenigno2020).ThecentralmechanismintheFTPListhatpricesadjustsothattherealvalueofgovernmentdebtequalsthepresentvalueoftaxeslessspending(Cochrane,2023).Morerecently,BianchiandMelosi(2022)developedatheoreticalframeworkwheremonetary-policyfiscalinteractionismoreacutewhenfiscalimbalancesarelargeandfiscalcredibilitywanes,makingitharderforthemonetaryauthoritytostabilizeinflationarounditsdesiredtarget.Intheirframework,afiscally-drivenriseintrendinflationdoesnotnecessarilystemfromalackofcredibilityofthecentralbank,butratherfromtheincompatibilitybetweentheobjectivesofthecentralbankandtheexpectedbehaviorofthefiscalauthorityincrediblystabilizingitsdebt.

Adifferent,butrelatedmechanismdevelopedmorerecentlyinArellanoandothers(2020)arguesthatsovereigndefaultriskonexternaldefaultablegovernmentdebtaffectsinflationexpectations.Intheirmodel,byassumption,inflationishigh(andconsumptionlow)wheneverthesovereigndefaultbecauseproductivityislow.Specifically,theyassumethattotalfactorproductivitydependsonthegovernment’screditstanding.Takingexpectations,whendefaultriskishigh,expectedinflationishigh.Thus,anyshockthatincreasesthesovereign’sdefaultrisk—forinstance,aproductivityoratermsoftradeshock—raises(near-term)inflationexpectations.Inthispaper,weidentifyshockstodebtthatareplausiblyorthogonaltoshocksthatmoveinflationandoutputandfindthattheseshocksarerelevantfortheconductofmonetarypolicyassummarizedbydislocationsoflong-termexpectationsinemergingmarketeconomies.Furthermore,weestablishthepresenceofnonlinearitiesbydemonstratinghighersensitivityofinflationexpectationstodebtsurprisesinhigh-debtandhigh-inflationemergingmarketeconomies.

DataandEmpiricalMethods

EconometricApproach

Ourgoalofassessinghowdebtsustainabilityconcernsmightimpingeonmonetarypolicyanditsabilitytoanchorinflationexpectationsfacesvariousempiricalchallenges,mostlyrelatedtoendogeneity.First,intherelationshipbetweendebtlevelsandinflation,causalityprobablyflowsbothways.Forexample,policymakersmaytightenfiscalpolicyinresponsetoariseininflationexpectations,whichcouldresultinanegativecorrelationofchangesindebtandinflationexpectations(Celasun,Gelos,andPrati,2004).Ontheotherhand,fiscalpolicyactionswhichaffect

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debtmayalsodirectlyinfluenceinflationexpectationsthroughaggregatedemandeffects,whichwewouldliketoexclude.Second,theco-movementbetweendebtlevelsandinflationcouldbespuriousanddriveninsteadbyanomittedvariable.Particularlyinemergingmarketeconomies,adverseGDPshocksstemming,say,fromasuddenstopofcapitalflowsasaresultofchangesinglobalriskaversionoftencomealongwithexchangeratedepreciationsthatinduceariseininflationexpectations.Insuchsituations,wewouldobserveasimultaneousincreaseinthedebt-to-GDPratioandinflationexpectationsthatisnot(necessarily)drivenbythemechanismswearetryingtocapture.Moreover,informationshocksthatmanifestaspositiveornegativeinterestrateshocks—reflectingacentralbankcommunicatingasurprisinglypositiveornegativeeconomicoutlook—couldcausehigher/lowernominaldebtalongwithhigherorlowerinflationexpectations(Nunesandothers,2022).Also,othershockstoinflationexpectationsthathaveanimpactonthenominalinterestratebill(hence,ondebtsustainability)couldintroduceapositive(negative)biasforlocal(foreign)currencydenominatedinstruments(Celasunandothers,2004).

Moreover,sinceweareinterestedinmechanismsrelatedtothegovernment’sintertemporalbudgetconstraint,asdiscussedearlier,totheextentpossible,wewouldliketoexcludeshort-terminflationarydemandeffectsstemmingfromfiscalexpansions.

Toaddresstheseconcerns,wepursueathreefoldstrategy.First,weuseforecasterrorsfromvariousvintagesofInternationalMonetaryFund(IMF)WorldEconomicOutlook(WEO)publicationstoidentifyunanticipatedexogenousshocks(surprises)togovernmentdebt,whichbothmitigateendogeneityconcerns.Moreover,debtsurprisesmaycapturechangesindebtthatdonotnecessarilymoveone-for-onewiththebudgetdeficitandarelesslikelytobedrivenbychangesingovernmentexpenditures(Singhandothers,2005).Forexample,suchdebtsurprisesmayincludetherecognitionofhiddencontingentliabilities.Second,wefocusonlong-terminflationexpectations(i.e.,5-yearaheadexpectations),whicharelesslikelytobeaffectedbyshort-termaggregatedemandeffects(assumingreasonableestimatesofaggregatepricestickiness).Third,tofurtherreducetheinfluenceofaggregatedemandeffectsandsimultaneity,wealsoconditionourestimationsonexistingdebtlevels;ifdebtsurprisesaffectlong-terminflationexpectationsmorethehigherpre-existingdebtlevelsare,thisisunlikelytostemfromsuchdemandeffectsorothershocks.

ThedebtshocksaredefinedasthedifferencebetweentherealizedannualgrowthrateofthedebttoGDPratioandthecorrespondingIMFforecast,whichispublishedinOctober.Inotherwords,theshockisunanticipatedchangeinthedebt-to-GDPratiothatisobservedinthelastquarterofeachyear.Specifically,thedebtsurprise,debtforcountryiattimetisdefinedas:

debt=−

wherethelowercasedebtvariablesdenotedebt-to-GDPratios.

Asarguedintheliteraturethatusesthisapproach(e.g.,BlanchardandPerotti,2002;AuerbachandGorodnichenko,2012,2013;Abiadandothers,2016;FurceriandLi,2017),debtlevelsprojectedintheOctoberWEOpublicationsarelikelytoreflectallavailableinformationatthetimeofpublication.

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DebtSurprisesandInflationExpectations

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AnydifferencebetweenrealizednominaldebtlevelsandtheOctoberWEOprojectionsthusaremorelikelytoreflectunanticipatedpolicychangesordebtrevaluations.

Oneconcernwiththegovernment-debtforecasterrorsisthattheymaynotrepresenttruesurprises,becausetheymaybeforecastable.Toverifythesensitivityofourresultstosuchissues,weconsidertwoapproachesfromtheliterature.First,wefollowthemethodusedintheOctober2017WEOandMagudandPienknagura(2022)byregressingthedebtforecasterrorsonforecasterrorsofinflationandrealGDPgrowthandusingtheresidualsfromthisregressionasourdebtshock.Theotherapproach,whichfollowsAuerbachandGorodnichenko(2013),consistsofregressingthedebtforecasterrorsonlaggedmacroeconomicvariables—outputgap,debt,andprimarybalance—withwhichtheforecasterrorsmightbepredicted.Theresidualsfromthisregressionarethenusedasthedebtshock.Inbothapproaches,weincludeasetofcountryfixedeffects.Theresultsandconclusionsdiscussedbelowarequantitativelyandqualitativelyrobusttothesealternativeshocks.

Aspreviouslydiscussed,governmentdebtshockscanaffectinflationexpectationsthroughmultiplechannels.Theimpactoftheseshocksonlong-termexpectationswilldependonthemonetarypolicyregime,thedegreeofcentralbankindependenceandotherinstitutionalfeatures,andtheanchoringofinflationexpectations.Thus,analyzingthesensitivityoflong-terminflationexpectationstounexpectedshiftsingovernmentdebthelpsshedlightonwhethernon-aggregatedemandmechanismsareatwork.

WeusepanelregressionsandthelocalprojectionsmethodofJordà(2005)toestimatetheresponsesoflong-terminflationexpectationstotheidentifiedgovernmentdebtshocksoverdifferenthorizons.AsnotedbyAuerbachandGorodnichenko(2012),thelocalprojectionsapproacheasilyaccommodatesnonlinearitiesinimpulseresponsefunctionsandcross-countrycorrelationintheerrorterm.

Thebaselinespecificationweestimateisgivenby:

几(H)t+l=a+v+Fut−s+几(H)t−j+xΓ+ei,t+ℎ,l=4,10,16,22,26,and34,(1)

where几(H)t+ldenotesthemeasureofinflationexpectationsforhorizonHforcountryiattimet+l,ut−su,t−saredebtsurprises,xtXisavectorofcontrols(tobeintroducedlaterasrobustness),ihandvtharecountryandtimefixedeffects,andei,t+ℎisarandomdisturbance.Weincludelagsjofthedebtshocktoreduceconcernsthatthedynamicsoftheimpactareduetopropertiesoftheshock(i.e.,thattheshockispersistentandtosomeextentpredictable)2asopposedtotheoperatingmechanisms.Thecoefficients,F,oftheresponseofinflationexpectationstodebtsurprises

2Severalauthorshavepointedoutthatanalystforecasts,includingWEOforecasts,aretosomeextentpredictable(e.g.,Celasunandothers2021forGDPforecasts).Debtforecasts,inparticular,showpositiveerrorsthatincreasewithdebt-to-GDPratios,andwhicharestatecontingent.Asnotedabove,forrobustnesswefilterthedebtsurprisesonotherendogenousvariableswithwhichdebtsurprisesmightbeforecastableandfindthatourresultsarequalitativelyandquantitativelysimilar.

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specificationareestimatedusingthewithinestimatorforeachprojectionperiod,withstandarderrorscomingfromDriscollandKraay’s(1998)heteroskedasticityandautocorrelation-consistentestimator.

Data

Thesampleincludes41emergingmarketanddevelopingeconomies,7low-incomeanddevelopingcountries,and34advancedeconomiesbetween2000and2020.3Wegrouptogetheremergingmarket-anddevelopingeconomies.Inflationexpectationsdataarecapturedusingsurvey-basedinflationforecastsfromprofessionalforecastersreportedbyConsensusEconomicsforfiveyearsahead.4Weuseinflationexpectationsdataatasemi-annualfrequencybecauseformostofoursample,intheConsensusEconomicsforecasts,long-terminflationforecastsareonlycollectedatasemi-annualfrequency(inAprilandOctober).Ourchoiceofexpectationsfromprofessionalforecastersisdrivensolelybytheconsistentavailabilityacrosscountriesofinflationexpectationsdata.5Dataongovernmentdebt,GDP,outputgap,andconsumerpriceinflationarefromtheIMF’sWEOdataset,whichcoversalleconomiesfrom1995to2019.Inconstructingourdebtshock,theforecastforgovernmentdebtandGDPforeachcountryinagivenyearistakenfromtheOctobervintageofWEOforecastsofthatyear.Therealizedvaluesofthesevariablesarethentakenfromthefollowingyear’sOctoberWEOdatabase.

Table1.SummaryStatistics

(Emerging)(Advanced)(Difference)

means.d.means.d.bt

Inf.Expectations,5-yrDebtSurprise

DebttoGDP

CPI,y-o-y

3.91

0.65

37.91

5.62

1.92

4.49

18.27

7.33

2.04

0.59

57.10

1.69

0.44

4.14

44.62

1.71

1.87***

0.06

-19.19***

3.93***

(17.92)

(0.19)

(-7.59)

(9.56)

Observations

352

426

778

WefollowFloresandothers(2023)incleaningthedatatominimizemeasurementerrorsandinconsiste