Government debt and inflation
Speech given by
Ben Broadbent, Deputy Governor Monetary Policy
2020 Annual Meeting of the Central Bank Research Association
London School of Economics via videolink
2 September 2020
I've received helpful comments from colleagues at the Bank of England. I'd like to thank
Jack Meaning, Nickie Shadbolt and Ryland Thomas and especially Mette Nielsen for their help in
preparing the speech. The views expressed are my own and do not necessarily reflect those of the
Bank of England or other members of the Financial Policy Committee or the Monetary Policy
Committee.
1
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Good afternoon. Thank you for asking me to speak to you today. This is an important and innovative time
for central banks, across their many functions, and it's vital we learn from our own and others' research on
the big questions. The Bank of England launched its new Agenda for Research1 yesterday and
Andy Haldane will I'm sure want to tell you more about it in the panel following this talk.
The topic I've chosen today certainly isn't a new one. In fact, it's almost as old as economics itself. I want to
talk about "monetary finance" - what it is (and what it is not), what it's worth and when it's been used in the
past.
Old it may be, but there's been quite a bit of talk about this topic very recently. In the face of the global
pandemic governments have taken significant fiscal actions to maintain incomes and preserve economic
capacity. At the same time, central banks have aggressively eased monetary policy. Because these things
have occurred alongside each other some commentators have suggested that central banks are engaged in
"monetary finance" of government deficits.
However, one of the points I want to make today is that the coincidence in time of easier monetary policy and
a higher government deficit doesn't really tell you anything about this question. That's because both are
naturally cyclical, especially when the central bank is targeting inflation. Economic slowdowns push up the
government's deficit. Because they'd otherwise depress inflation they also tend to result in easier monetary
policy. Depending on how persistent the downturn is expected to be - and, because capital markets are
global, on how widespread it is - you might even expect to see lower longer-term bond yields as well, even
as the government is obliged to sell more debt and even without any extension of QE. There is nothing
intrinsic in the nature of these transactions, or in the co-movement of these various economic series, that
constitutes "monetary finance".
What really lies behind that term is instead an institutional question: who is doing what and why? Is
monetary policy controlled by an independent authority, using its tools solely in pursuit of a fixed nominal
objective? Or is there "fiscal dominance" over the central bank, which is then forced to subordinate its own
objectives to those of the fiscal authority?
Because they naturally respond to the economic cycle, looking at the instruments of policy on their own
(fiscal and monetary measures) doesn't really help you that much in distinguishing one situation from the
other. A better method might simply be to look directly at the institutional arrangements themselves (are
monetary and fiscal policies determined by independent agencies? how is that independence
safeguarded?). As this is ultimately a question of ends rather than means, a better measure still is the
behaviour of objectives of policy. If inflation rises materially above its target, and if it tends to do so in
particular when the public finances are under strain, that may be evidence of "fiscal dominance". If, on the
1
See https://www.bankofengland.co.uk/research/bank-of-england-agenda-for-research.
2
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other hand, easier monetary policy is necessary simply to stabilise inflation, and succeeds in doing so, it's
hard to see how it can qualify as "monetary finance", no matter how the fiscal balance is behaving2.
That's not to say the fiscal position is wholly irrelevant because higher inflation may help - if only to a
degree, and at a wider economic cost - in easing fiscal constraints. Very high levels of debt could therefore
test those institutional arrangements. If its debt was so onerous that the government could not or would not
finance it by conventional non-inflationary means, and if the independence of the central bank were
sufficiently fragile, inflation could come to be viewed as just another tax, rather than something to be
stabilised in its own right. In extremis, when the credibility of the macroeconomic framework is entirely lost,
inflation expectations - indeed inflation itself - would be determined solely by the fiscal position. Even a
notionally independent central bank could do nothing to affect it. Purchases of government debt by the
central bank, for example, would do nothing to depress their yields. (Indeed, if they served only to reinforce
the central bank's subservience, thereby pushing up expectations of future inflation, QE could actually raise
bond yields. Put another way, the policy can only work as intended to the extent the framework is credible -
if it's generally accepted that deficits are controlled by conventional fiscal measures and monetary policy is
devoted to a fixed nominal objective.) There is also the potential, in this extreme situation, of a positive
feedback between inflation expectations and inflation itself, and an associated risk of hyperinflationary
spirals. When inflation expectations rise, the expected cost of holding zero-interest money goes up as well.
Reluctant to hold on for very long to the paper the government is using to fund itself, people spend it
straightaway, feeding the inflation and confirming those prior expectations.
Whether inflation is actually an efficient tax - whether the economic harm it causes is worth the fiscal benefit
- is far from clear. Certainly an extra bout of inflation that's fully anticipated, and that therefore raises
nominal interest rates and bond yields in advance, does very little to improve the government's financial
position, and even less now than in the past. That's because the public sector has almost nothing in the way
of zero-interest liabilities.
If higher inflation and nominal growth pushed up the demand for physical cash the government might make a
little more from that source. (The economic value of cash is higher than the cost of producing it. The
difference, known as "seigniorage", is a source of revenue for the public sector3). But the sums involved are
2
On their own, the instruments of policy are not a reliable way to discern whether there's "monetary finance" of the government. But
they may be more informative alongside other information. For example, if the central bank is easing policy in the face of clear
inflationary pressure that might suggest it's putting weight on some other objective: the joint behaviour of instrument and target can be
informative. It might also tell you something if the central bank eased policy and, at the same time, the authorities introduced
restrictions to limit or prevent people from selling the government's debt. That way, the central bank might be able to reduce borrowing
costs for the government alone - i.e. to raise the price of its debt - but avoid the inflationary consequences of an economy-wide easing
in monetary conditions (so-called "financial repression"). But those restrictions would have to be material (they'd need to cover
international capital flows as well, for example) to prevent people selling domestic government debt in favour of other assets. At least in
developed economies, and with today's open capital markets, such restrictions no longer exist. I'll touch on this point again in the first
section of the talk.
3
The term "seigniorage", which derives from the French word "seigneur" or "lord" (the state having the monopoly right to issue
currency), is used a bit loosely. The most common usage is the one I've described here (the revenue from issuing new currency).
Sometimes people have also used the term for the effects of inflation on existing liabilities, something we'll look at later in the talk, or the
overall revenue of the central bank. Buiter (2007) defines these different concepts in detail. Reis (2019) gives a very clear exposition of
all the means by which a central bank could affect the fiscal position. My colleagues on the MPC have also discussed this relationship
(Bailey (2020), Vlieghe (2020)).
3
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tiny: from today's starting point an extra percentage point of growth in the stock of banknotes would bring in
less than one thousandth of what the government spends every year.
As for the "money" created by QE - reserve deposits held by commercial banks at the central bank - there's
a very important difference between this and the "money" in simple textbook accounts of inflation: those
reserves pay interest. If QE had been financed by the zero-interest money of the textbook, and if inflation
subsequently went up, the real value of the public sector's liabilities would decline, even if nominal interest
rates and bond yields had risen in anticipation. Some portion of the public sector's interest-bearing liabilities
would've been replaced with a "money" that bears none.
When reserves pay interest
Chart 1: Rapid inflations are often fiscal events
that's no longer the case.
This is why it's not strictly
correct to say that QE
"monetises" the government's
debt. The policy is more
accurately seen as a maturity
swap, in which one (longer-
term) interest-bearing liability
of the state is replaced with
another, shorter-term version
of the same. As we'll see, the
shortening of their average
From "This Time Is Different: Eight Centuries of Financial Folly" by Carmen M. Reinhart and
Kenneth S. Rogoff. Copyright © 2009 by Princeton University Press. Reprinted by permission
maturity reduces the scope
of the publisher.
for inflation to reduce the real
value of the public sector's
liabilities.
Whatever the fiscal consequences of higher inflation today, and whatever they were in the past, it's clear
there are many examples in economic history of unsustainable fiscal positions leading to a wholesale loss of
monetary control. Weimar Germany in the 1920s is one well-known example. Post-revolutionary France, in
the 1790s, is another. There are more recent instances in some emerging economies. Hyperinflations of
this sort are essentially fiscal events. Chart 1, taken from the well-known book about financial crises by
Reinhart and Rogoff4, shows that waves of formal defaults on governments' debts have broadly coincided
with waves of rapid inflation.
Nor do you have to go to such extremes, or away from these shores, to find episodes in which the nominal
anchor has been abandoned (if only for a time) in the face of big increases in government spending. Britain
4
Reinhart and Rogoff (2009)
4
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suspended the gold standard during the Napoleonic wars and again at the onset of the First World War.
Prices rose significantly, particularly during WWI, and yields on government debt did so as well.
But the relationship between debt and inflation isn't a simple one, nor is it readily apparent in the long-term
UK data.
For example, if there was "monetary finance" during these two episodes it's not something that endured
because, in both cases, Britain restored the original price of gold after those wars had ended. If rising price
levels had conferred any fiscal benefit while they were being fought, that was then reversed, via deflation,
once peace was established. Any long-lasting reduction in government debt had to be achieved by running
a tighter fiscal policy.
And although inflation also rose during the Second World War, and was much more persistent afterwards -
with monetary policy in the hands of the government many argue this does count as a period of "fiscal
dominance" over, or at least "fiscal influence" on, that policy - it was at least brought down, and contained to
a degree5, by the fixed exchange rate of the Bretton Woods system. Only in the late 1960s and 1970s, once
Bretton Woods broke down and by which time government debt ratios were already much lower, did inflation
really take off.
Finally, to tick off one more relevant episode, we
Chart 2: But in British history there is no correlation
between public-sector debt and inflation
all know that the financial crisis of 2008-09 was
followed by rapid and material rises in public-
sector indebtedness. Yet despite this, and despite
large-scale monetary easing as that rise was
occurring, inflation remained close to target.
Indeed, for much of the post-crisis period many
developed country central banks have found
themselves battling rates of inflation that are too
low, not too high.
All in all, taking the past three centuries as a
Sources: Thomas and Dimsdale (2017), Mitchell (1988), Feinstein
(1991), Crafts and Mills (1994), Feinstein (1998), O'Donoghue et al
whole, the correlation between public-sector
(2004), ONS and Bank calculations.
indebtedness and inflation - whether that's
measured contemporaneously or after the event -
is zero (Chart 2).
I think we can draw a few lessons from this.
5
I say "to a degree" because the constraint wasn't fully binding. Sterling was devalued in 1967, even before Bretton Woods started to
break down.
5
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First, the fiscal position is not, on its own, a reliable predictor of inflation. The prevailing institutional
arrangements, and in particular the integrity of the monetary regime, matter at least as much. It's hard to say
whether the UK government's concern about its financial position was in any sense a cause of the inflation of
the 1970s and early 1980s. There were probably many contributing factors. But it's surely at least as
relevant that there was no fixed nominal anchor guiding monetary policy and no independent authority
setting it.
Also relevant is the cause of the increase in government debt. In wartime, debt goes up because the
government is spending significant sums on actual goods and services, thereby putting significant pressure
on economic resources. It buys more stuff and employs more people. All else equal, this is inflationary. It
often requires real interest rates to rise, in order to "crowd out" spending by the private sector and its demand
for those same resources. After the financial crisis, by contrast, debt rose not because government spending
on goods and services went up but because, in the face of a sharp downturn in private-sector demand, tax
receipts collapsed. The downturn in aggregate demand, actual and expected, depressed the appropriate
level of real interest rates and bond yields. All else equal - for a given setting of monetary policy - it was
also disinflationary.
Qualitatively, at least, the same thing is going on right now. Public sector debt has risen significantly, across
the developed world, in response to the pandemic. But, as was the case after the financial crisis, this has
not been caused by any material rise in governments' spending on goods and services, or their direct
demand for underlying economic resources. It's because tax receipts have fallen sharply and, more
materially, because governments have compensated people for the impact of mandated lockdowns. Private
and aggregate demand have fallen, below the economy's supply capacity - despite these huge transfer
programmes, rates of unemployment and wider measures of spare capacity are rising. And it's in response
to these disinflationary pressures that independent central banks everywhere, including in the UK, have
eased monetary policy.
Anyhow, having set out at some length the points I want to make, I hope I can be reasonably concise in the
body of this talk. I'll cover first the cyclicality of interest rates under inflation targeting. Via some very simple
simulations I'll then look briefly at the impact of inflation on the public finances, focusing in particular on the
effect of paying interest on central bank reserves. After an equally brief canter through some of the relevant
bits of UK history there's a short concluding section.
How interest rates and bond yields respond to shifts in demand
Concerns about "monetary finance" have arisen because policy has been eased at the same time the
government's deficit has gone up. The main problem with this argument is that the monetary stance and the
fiscal balance are both cyclical - they tend to rise in upswings and fall in downturns. You'd therefore expect
6
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them to be correlated this way. In fact, in the UK data, short-term interest rates have become more tightly
correlated with economic growth since inflation targeting was introduced.
Since the financial crisis, with policy interest rates pressed up against the effective lower bound, QE has
instead become the marginal instrument of policy for many central banks. With much less of a track record
to go on, it's harder to demonstrate as clearly the cyclical behaviour of asset purchases (though the direction
of the correlation - QE tends to happen when growth is weak - is clear enough). Nor is the pro-cyclicality of
bond yields as evident as it is for short-term interest rates.
Nevertheless, if an economic downturn were sufficiently widespread, and expected to persist for some time,
it's quite possible that expected future interest rates (and therefore bond yields) would decline of their own
accord, even without the assistance of QE and even if one of the consequences of the downturn was also a
rise in public-sector borrowing. There is no correlation either, in the long-term UK data, between long-term
bond yields and levels of government debt.
That's not to say that QE has no effect on monetary conditions. At least for a time, and like a reduction in the
policy rate, it helps to reduce the real cost of borrowing, for the private as well as the public sector. But it's
important to understand that policy is only one of many influences on those costs. A "model" of bond yields
that has them responding only to public-sector debt issuance, with or without purchases by the central bank,
performs very poorly in the data. One cannot conclude from a coincidence of higher government borrowing
on the one hand and lower interest rates on the other (whether short or longer-term) that monetary policy is
doing anything other than what it should do. As I said in the introduction, the acid test is ultimately the
behaviour of inflation itself.
Anyhow, let's have a look at some of the numbers, starting with short-term policy changes. Charts 3a and 3b
get across clearly the correlation with economic activity under inflation targeting. For the post-crisis period
they both make some attempt to include shifts in QE, via a translation into the equivalent change in Bank
Rate. The first plots changes in the resulting shadow rate (as developed by De Rezende and Ristiniemi
(2020)) against the growth of GDP. Chart 3b uses slightly different measures for the same things - the
average policy vote on the MPC and a survey measure of growth6 - but the conclusion is the same. Policy is
tightened when growth is strong and loosened when it's weak. It's no surprise to find that the government
balance is similarly cyclical (3c) - or, therefore, that it's also well correlated with the behaviour of monetary
policy.
Furthermore, the responsiveness of policy rates to economic growth seems to be necessary to stabilise
inflation. Certainly inflation has been very stable under inflation targeting (more stable, in fact, than in any
25-year period in the 800-year history of the estimated UK series). And you have to go back all the way to
6
A weighted average of the composite PMI and (to cover the distribution sector) the headline balance from the CBI distributive trades
survey.
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the pre-WWI classical gold standard, the last time the UK had something akin to a "target" for domestic
prices7, to find a period when short-term interest rates were reasonably well correlated with economic growth
- or in which inflation was well controlled (Chart 4).
Chart 3a: Monetary policy and economic activity Chart 3b: Also apparent using MPC votes and
correlated under inflation targeting survey measure of growth
Sources: De Rezende and Ristiniemi (2020), ONS and Bank 6-month averages, combined IHS Markit/CIPS and CBI distributive
calculations. trades lagged one month. Sources: ONS, IHS Markit/CIPS, CBI,
Bank of England and Bank calculations.
Chart 3c: Government balance also cyclical Chart 4: When the monetary regime is stable policy
rates are more responsive to economic growth and
inflation is less volatile
Sources: ONS and Bank calculations. Based on GDP growth and inflation smoothed over 2-year periods,
and Bank Rate changes over 2 years. Sources: Thomas and
Dimsdale (2017), Feinstein (1991), O'Donoghue et al (2004), ONS
and Bank calculations.
In the interim, and especially during and between the two world wars, the correlation between interest rates
and economic growth was lower and the volatility of inflation higher. This is as you'd expect. To stabilise
7
With the nominal price of the metal fixed, the effective target for the price of goods and services in a gold standard regime is the
inverse of its real equilibrium price. A rise in the supply of metal, from new discoveries for example, leads to inflation in the CPI
(allowing the real price of gold to fall). If demand for gold rises (for example because of strong economic growth more generally),
without any increase in the supply, the CPI tends to fall. Subject to these variations, a gold standard amounts to a target for the level of
the CPI.
8
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inflation the monetary authority needs to lean against the cycle, at least when it's driven by swings in
demand8.
If the link between short-term interest rates and economic growth is reasonably clear, at least during stable
monetary regimes, the cyclicality of longer-term bond yields is less so. In the data they're essentially
acyclical (none of the orange bars in Chart 5 is statistically distinguishable from zero). Nor is there any
empirical correlation between bond yields and the level of government debt (Chart 6).
Chart 5: No significant correlation between Chart 6: No relationship in long-term UK data
economic growth and changes in long-term bond between level and cost of government debt
yields
Sources: Thomas and Dimsdale (2017), Capie and Webber
(1985), Neal (1990), Klovland (1994), Odlyzko (2014), ONS, DMO
Based on GDP growth smoothed over 2-year periods, and
and Bank of England.
changes in Bank Rate and consols / long-term government bond
yields over 2 years. Sources: Thomas and Dimsdale (2017),
Klovland (1994), Capie and Webber (1985), ONS, DMO,
Bank of England, and Bank calculations.
I don't think we should be terribly surprised by this. As far as the link with economic growth is concerned, we
should remember that bonds are long-term assets. Their yields will therefore depend more on expectations
about how the economy behaves over the future than on what's happening to growth right now. There may
have been specific instances, when such things can be isolated in the data, in which positive demand shocks
pushed up bond yields. Using the same pre-WWI British data, Barro (1987) finds that wartime spending by
the government was associated with higher long-term interest rates. He attributes this not to the effect on
the fiscal position but to the direct pressure of the extra spending on economic resources: in order to keep
aggregate demand in line with supply real interest rates, including those at longer maturities, needed to go
up to "crowd out" private spending. In general, however, swings in demand will tend to have less impact on
forward rates - and therefore on longer-term bond yields - than on current, spot interest rates.
8
For more on the countercyclical impact of monetary policy, see for example Christiano et al (1999), Boivin et al (2010) and Ramey
(2016).
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In addition, capital markets are now very open and Chart 7: Global factors much more important
determinant of changes in gilt yields than domestic
the UK a far smaller part of the world economy
events
than it once was. So at least as far as real bond
yields are concerned, it's the future of the global
economy that matters more than that of the UK
specifically. Changes in real bond yields are
tightly correlated across developed economies
(Chart 7); news about the world economy has a
greater impact on gilt yields than news about the
UK specifically9.
The fact that international capital markets are now
very open - and that the UK is now only a small 12-month changes in 10-year yields. Sources: UK line -
Bloomberg Finance L.P, TradeWeb and Bank calculations, US and
part of the world economy - also has a bearing on German lines - Bloomberg Finance L.P. and Bank calculations.
the effect of changes in public-sector debt. When the UK government borrows money it's tapping a global
market for savings, not just a domestic one. And from the perspective of a relatively small, single borrower -
certainly one who's still judged to be creditworthy - a greater demand for credit needn't have any impact on
what is essentially a global price.
This doesn't mean a country's fiscal position never matters at all. Just as for an individual household or
company, a government's creditworthiness can affect the risk premium it's charged for new borrowing. If
there's a concern that high levels of debt might result in some sort of default - whether directly or in the form
of a sudden burst of inflation - you'd expect to see that reflected in some sort of extra margin on its bond
yields10.
But that's a long way from saying that any variation in public-sector debt will have a measurable impact on its
price. It's further still from the claim that such an effect should be the dominant (let alone the only) influence
on yields. Clearly, that's not what the data tell you.
Before closing this section I should make one other point. I'm taking it as given here that monetary policy
does actually have some effect on demand and inflation (all else equal), through all the channels we know
about. I mention this only because some of the commentary claims not so much that QE is potentially
fuelling too much inflation, and helping governments that way, but that it's doing so by artificially depressing
the cost of new debt issuance in a manner that does not (somehow) have any impact on inflation.
9
Broadbent (2014). Note that, while the impact of QE is arguably detectable in Chart 7 - the launch in 2009, for example, in the UK and
the US, and again this year - it's not as if bond yields are (or were) otherwise static. They moved around just as much beforehand,
generally downwards over this period and especially so during global downturns. They might reasonably have been expected to do so
in response to the pandemic, even without QE. Nor are these changes well correlated with fiscal news. As I said earlier, a model of
bond yields that has them responding only to government debt and/or QE performs poorly in the data. For more on what's depressed
long-term "neutral" interest rates, see for example, Vlieghe (2018), Broadbent (2014) and the August 2018 Inflation Report.
10
If the perceived risk were that the authorities would try to "inflate away" the debt, it would be priced into conventional bonds alone (and
therefore into the "breakeven" spread between the yields on conventional and indexed debt); if people worried about formal default
yields on both would be affected.
10
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For what it's worth, as a matter of terminology, I think this would more accurately be described as "financial
repression" than "monetary finance". Either way, I don't really see how it's possible to do this, not least
because of the open, global capital markets in which all borrowers, public and private alike, now operate.
If the claim is that even variations in the financial conditions facing the private sector have no bearing on
inflation, one wonders how monetary authorities (including the MPC) are able to control it to begin with. It's
surely not a coincidence that inflation has been stable only when there's been a stable regime for monetary
policy. That wouldn't be possible unless policy routinely had an effect on it. Chart 4 is informative in this
respect.
Financial repression might be more feasible if it were possible to depress the yield on government debt alone
(i.e. to raise its price), leaving untouched financial conditions facing the private sector. But if that artificial
gap were to endure for any length of time it would require quantitative restrictions of some kind, to prevent
people selling domestic government debt for some other (relatively under-priced) asset. And because
holders of UK assets live abroad as well as at home, those restrictions would have to cover international
capital markets as well11.
Yet we know such restrictions don't exist. We know that central bank policies do affect financial conditions
facing the private sector, not just the public sector. And we know that monetary policy makers can, and do,
thereby affect inflation. Indeed, in the longer run, it's all they can affect and - barring the sorts of restraints
necessary for financial repression - the only enduring means by which they can have an impact on the real
value of public-sector debt. We'll now have a look at how that works.
What higher inflation does to the public sector's liabilities: a simple simulation
As I said in the introduction, levels of government debt that are ultimately unaffordable - that the government
cannot (or will not) finance through conventional fiscal measures - can in extremis present a threat to the
stability of inflation. That's because inflation - above all surprise inflation - can reduce the burden of that
debt. What I want to do here is use a simple, stylised simulation to gauge the scale of this effect.
I'm interested only in the pure effect of higher inflation. So the simulation assumes that all the real
determinants of indebtedness - the path of real GDP, real (ex ante) bond yields and the government's
primary deficit (relative to GDP) - are all fixed. This is unrealistic. In the short term generating the higher
inflation would probably require a period of lower real interest rates (if only a brief one, relative to the
timescales involved). Going the other way, very rapid inflations have been bad for real output growth and
they've also tended to push up the real cost of public-sector debt thereafter, via a higher risk premium. For
those reasons, and even from the narrow perspective of the government finances alone, I think these
11
Giovannini and de Melo (1993).
11
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simulations should be seen as relatively optimistic, at least over the longer term. But they do at least give us
some sort of handle on the marginal effects of higher inflation.
As a starting point, we should begin by recognising that if the extra inflation is fully anticipated it will have
very little impact on the public finances. That's because investing institutions, which care about real returns,
could then take account of it in the price they're prepared to pay for the debt. If everyone knew in advance
that inflation was about to rise permanently by (say) 1% point you'd expect nominal yields to be 1% point
higher, across the curve, than they otherwise would've been. In real terms, the government wouldn't pay any
less for its debt - the newly sold debt, at least - even after the inflation arrives. The real value of the
principle declines by an extra one per cent a year. But the interest payments - the coupons - are also a
percentage point higher.
For holders of a long-term bond, however, it's quite a tall or