Spurred on by very low rates, governments issued $ 16.3 trillion in debt in 2020, and are expected to borrow another $ 12.6 trillion this year, according to S&P Global Ratings. But fears are growing that an explosive economic return starting this summer could generate inflation, potentially forcing central banks to raise rates earlier than expected.
Many economists think that the threat of inflation can be exaggerated. But political leaders, concerned about having to make difficult concessions in the years to come, are watching the situation closely.
Waiting for inflation
The changes were triggered in part by increased confidence in the next phase of the pandemic. As vaccination campaigns allow governments to lift some restrictions, consumers are expected to rush to restaurants and board planes. This could raise prices, which central banks have pledged to keep under control.
Still, S&P Global Ratings pointed to inflation as a potential concern in a report on sovereign debt this month, noting that “it could lead central banks to raise interest rates, partially reversing the benefits of low debt service costs. “.
“A big jump in interest rates would be very expensive,” said Ugo Panizza, professor of international economics at the Geneva Graduate Institute. “Central banks will face very, very complicated offsets if inflation increases.”
UK sounds the alarm
The Congressional Budget Office projects that the public debt of the United States will rise to almost $ 22.5 trillion by the end of fiscal year 2021. This is equivalent to 102% of the annual gross domestic product. In Italy, the proportion was 154% at the end of September, while Greece was at almost 200%.
High levels of indebtedness leave public finances more exposed to rising interest rates. Consider the United Kingdom, where public sector debt has also skyrocketed to a level that almost equals the size of the economy.
The Office for Budget Responsibility estimates that if short- and long-term interest rates increase by just 1 percentage point, debt interest spending would increase by £ 20.8 billion ($ 29 billion) in the fiscal year 2025-26.
While this is not necessarily unsustainable, it is definitely not desirable, according to Isabel Stockton, an economist at the UK Institute of Tax Studies.
“Everyone would prefer to give those £ 21 billion to the [National Health Service] or [to] improve the welfare system or the infrastructure, “she said.
Interest costs are even more sensitive to inflation and rate hikes due to the response to the pandemic.
The UK government borrowed £ 270.6 billion ($ 377 billion) between April 2020 and January 2021, and higher interest rates mean increased payments on that debt.
About a quarter of the UK government’s debt is linked to inflation, according to the Institute for Fiscal Studies, which means that payments will automatically increase if prices rise. In addition, the Bank of England purchased huge amounts of government debt as part of its quantitative easing program. The central bank pays interest on the reserves it creates to make these purchases.
If interest payments go up while economic growth slows down, politicians are left with difficult choices: raising taxes to cover the budget deficit or cutting spending.
Sunak made the country’s debt burden a central issue by revealing its spending proposals last week, which included plans for a big tax hike on the biggest British companies in 2023.
“Just as it would be irresponsible to withdraw [economic] support too early, it would also be irresponsible to allow future loans and debts to go out of control, “he said.
A global problem
Similar dynamics can occur worldwide.
The Organization for Economic Cooperation and Development said in a report last month that, while interest costs are currently low, high levels of existing debt, combined with continuing borrowing needs, have increased refinancing risks. About a quarter of the debt traded on member countries’ markets – or $ 14.1 trillion – will mature in one year, according to the agency.
“It is a real concern,” said Randall Kroszner, who served as governor of the Federal Reserve from 2006 until 2009. If US debt payments suddenly “from very low to quite significant”, it could weigh on the economic recovery and downturn in activity , he added.
Countries that do not control their own currencies may be in especially tight positions, said Panizza. Italy, which uses the euro, is an example.
Panizza said that Italy needs to refinance or extend the maturity of about one-seventh of its debt each year. If interest rates increased by 2%, that would add about half a point of GDP, or about $ 9.9 billion, to the cost of servicing the debt annually. It is a “substantial” amount, he emphasized.
A peak in inflation may never materialize; for decades, global inflation has remained stubbornly silent. And an expanding economy would also increase the amount of money governments get from taxes, helping to alleviate deficit anxiety.
But there is no denying that central banks can face a difficult set of choices as the world economy emerges from an unprecedented shock and a wide range of results remain on the table.
“We don’t have much experience with that,” said Kroszner.