Desperate to save their economies from total collapse, governments borrowed unprecedented the amounts cheap money to support workers and businesses during the pandemic. Now with recovery in sight, a big risk looms: interest payments.
Boosted by floor rates, governments issued $16.3 trillion in debt in 2020, and they are expected to borrow another $12.6 trillion this year, according to S&P Global Ratings. But fears are growing that an explosive economic comeback starting this summer could generate inflation, potentially forcing central banks to raise rates sooner than expected.
If that happens, the cost of servicing mountains of sovereign debt will rise, gobbling up public funds that could otherwise be spent on essential services or rebuilding weakened economies. US lawmakers have approved a mammoth $1.9 trillion stimulus package on Wednesday, it could push prices higher and increase pressure on the Federal Reserve.
Many economists think the threat of inflation may be overstated. But political leaders, worried about having to make difficult compromises in the years to come, are watching the situation closely.
“Borrowing costs are affordable right now, but interest rates and inflation may not stay low forever,” warned UK Finance Minister Rishi Sunak. when the UK government’s budget was announced earlier this month.
Waiting for inflation
Concerns about rising interest rates surfaced as investors discharge state obligations. The yield on the benchmark 10-year US Treasury note recently rose above 1.6% to its highest level in more than a year. Meanwhile, the yield on UK 10-year bonds rose above 0.8% at the end of last month, a sharp rise from less than 0.2% at the start of the year.
These measures were triggered in part by growing 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 jump on planes. That could drive up prices, which central banks have pledged to keep in check.
Policy makers downplayed the threat. Federal Reserve Chairman Jerome Powell, speaking last week, said he expect inflation to rise as the economy reopens, but stressed that the Fed will try to differentiate between a “one-off price increase and continued inflation,” indicating it is in no rush to change course. European Central Bank President Christine Lagarde is expected to send a similar message later Thursday when she addresses reporters.
Still, S&P Global Ratings highlighted inflation as a potential concern in a sovereign debt report this month, noting that it “could push central banks to raise interest rates, partially offsetting the benefits of low debt servicing costs”.
“A sharp rise in interest rates would be very costly,” said Ugo Panizza, professor of international economics at the University Institute of Geneva. “Central banks will face very, very complicated trade-offs if inflation rises.”
UK is sounding the alarm
The Congressional Budget Office projects that publicly held public debt in the United States will reach nearly $22.5 trillion by the end of fiscal year 2021. This is equivalent to 102% of annual gross domestic product. . In Italy, the ratio stood at 154% at the end of September, while Greece was close to 200%.
High debt levels make public finances more exposed to interest rate hikes. Take the UK, where public sector debt has also soared to a level where it almost equals the size of the economy.
The Office for Budget Responsibility estimates that if both short-term and long-term interest rates were to rise by just 1 percentage point, interest expenditure on debt would rise by £20.8 billion ($29 billion). dollars) in fiscal year 2025-26.
While this isn’t necessarily unsustainable, it’s certainly not desirable, according to Isabel Stockton, an economist at the UK’s Institute for Fiscal Studies.
“Everybody would rather give that £21billion to the [National Health Service] Where [to] improve the social protection system or the infrastructure,” she said.
Interest costs are even more sensitive to inflation and rate hikes due to the pandemic response.
The UK government borrowed £270.6 billion ($377 billion) between April 2020 and January 2021, and higher interest rates mean higher payments on that debt.
According to the Institute for Fiscal Studies, around a quarter of Britain’s public debt is inflation-linked, meaning payments automatically increase if prices rise. On top of that, the Bank of England bought 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 rise while economic growth lags, politicians are faced with stark choices: raise taxes to cover the budget deficit or cut spending.
Sunak made the country’s debt burden a central issue when unveiling his spending proposals last week, which included a steep tax hike on the largest UK businesses in 2023.
“Just as it would be irresponsible to withdraw [economic] support too soon, it would also be irresponsible to allow future borrowing and debt to go unchecked,” he said.
A global problem
A similar dynamic could play out around the world.
The Organization for Economic Co-operation and Development said in a report last month that while interest charges are currently low, high levels of existing debt, combined with continued borrowing needs, have increased downside risks. refinancing. About a quarter of member countries’ market-traded debt — or $14.1 trillion — will mature within a year, the agency said.
“It’s a real concern,” said Randall Kroszner, who served as Federal Reserve governor from 2006 to 2009. If U.S. debt payments suddenly jump from “pretty low to quite large,” it could weigh on recovery and slow the economy. activity, he added.
Countries that don’t control their own currencies could find themselves in particularly tight positions, Panizza said. Italy, which uses the euro, is an example.
Panizza said Italy needed to refinance or extend the maturity of about a seventh of its debt every year. If interest rates were to rise by 2%, that would add about half a percentage point of GDP, or about $9.9 billion, to debt servicing costs each year. It is a “substantial” amount, he stressed.
Emerging market economies like Turkey or Brazil could also be vulnerable. Higher interest rates tend to strengthen the dollar, a move that has already begun. This can increase maintenance costs. Meanwhile, government revenues in these countries could be affected by continued weakness in the tourism sector.
A spike in inflation may never materialize; for decades, global inflation has remained stubbornly subdued. And a booming economy would also increase government tax revenues, which would help alleviate some deficit concerns.
But there’s no denying that central banks could face a series of tough choices as the global economy emerges from an unprecedented shock, and a wide range of outcomes remain on the table.
“It’s not something we have a lot of experience with,” Kroszner said.