Fiscal Implications of Interest Rate Normalization in the United States

IMF Working Papers, May 3, 2019

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Unexpected inflation reduces the real value of government liabilities.
A rising policy rate increases government financing needs through:
- higher interest payments, and
- lower real bond prices.
Interaction of these forces produces a non-monotonic path for the real government debt burden:
- an initial decline in the real debt burden, followed by a rise even when tax revenues increase during an expansion.

Given the current net debt-to-GDP ratio at around 80 percent, interest rate normalization leads to a negligible increase in the sovereign default risk of the U.S. federal government.
This negligible increase in default risk occurs despite a much higher federal debt-to-GDP ratio than the post-war historical average.

The analysis emphasizes monetary and fiscal policy interaction using New Keynesian and non linear DSGE models.
Technical constructs and keywords highlighted in the study include:
- devaluation effect, equilibrium debt valuation equation, fiscal sustainability,
- Capital income tax, income tax, interest payments, interest rate normalization,
- liabilities decline and debt level dynamics.

Policymakers should consider that:
- Inflation episodes can mechanically reduce real liabilities, but
- normalization of the policy rate raises financing needs via higher interest payments and depressed bond prices, which can reverse initial improvements in the real debt burden.
Fiscal planning should account for the dynamic, potentially delayed, increase in the real debt burden following interest rate normalization, even in periods of rising tax revenues.

Source: Fiscal Implications of Interest Rate Normalization in the United States (IMF Working Paper).