Government debt changes the impact of monetary policy

High debt levels in a country can diminish the effectiveness of monetary policy. This is because when the central bank raises interest rates to combat inflation, the higher borrowing costs burden the government's finances the most. Consequently, the government may either increase its deficit or reduce spending in other areas to maintain the same deficit levels.

If the government opts for a larger deficit, investors might anticipate higher future inflation to help eliminate the excess debt. On the other hand, if they cut spending, they may expect slower GDP growth.

A Bank for International Settlements (BIS) study reveals this impact. For European countries with debt-to-GDP ratios of 60% and 120%, a one standard deviation increase in ECB policy rates (around 50 basis points) leads to a 1.75% GDP reduction after a year in the low-debt nation. However, in the high-debt country, the damage is 2.25% after three quarters. This is due to the larger share of maturing debt needing replacement to fund higher interest rates.

Moreover, the price impact is more pronounced in countries with lower debt levels. To cope with rising debt, high-debt countries are more likely to allow inflation to run higher. This, in turn, alters businesses' and households' expectations of future inflation, influencing actual prices.

Furthermore, the study shows that the impact of monetary policy changes on GDP and prices follows a U-shaped curve. Shorter maturity bond yields experience a larger effect on output and inflation when the central bank hikes rates. However, longer maturity bonds (over 8 years) show increased impact. Countries heavily reliant on long-duration bonds, like the UK, suffer more from higher interest rates than nations focusing on intermediate maturity bonds, such as France, even if their debt-to-GDP ratios are similar.