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The US Inflation Bonanza for Sovereign Debtors

During the “Great Moderation” that preceded the COVID-19 pandemic, years of low inflation led to the growth of sovereign debt issued at fixed interest rates and long maturities. And now, two years of unexpected US inflation have effectively diluted these obligations, in America and elsewhere.

CAMBRIDGE – As developing countries confront a new era of elevated inflation, rising interest rates, a stronger dollar, and capital outflows, some governments stand to benefit from a little-noticed bonanza. During the “Great Moderation” that preceded the COVID-19 pandemic, years of low inflation led to the growth of sovereign debt issued at fixed interest rates and long maturities. Now, two years of unexpected inflation in the United States have effectively diluted this debt.

According to our calculations, the US government’s own inflation windfall is substantial. In October 2019, the International Monetary Fund’s World Economic Outlook forecast that US inflation would be 2.4% in 2021 and 2.3% in 2022. But US inflation clocked in at 4.7% in 2021, and the IMF now expects a rate of 7.7% this year. The size of what we call the “unexpected inflation shock” over 2021-22 is thus 7.7% (the sum of the actual inflation rates minus the projected rates). Under such conditions, the biggest winner will be the largest issuer of dollar debt: Uncle Sam.

At the end of 2020, the US government’s long-term fixed-rate debt was nearly $21 trillion, and the US monetary base (which includes the amount of currency in circulation) was about $5.2 trillion. While the full brunt of 2021-22 inflation (12.4%) falls on the monetary base, its unexpected component (7.7%) reduces the value of the US government’s debt, because debt holders are compensated with interest for expected inflation. The US Treasury thus nets an enormous $2 trillion reduction – nearly 11% of GDP – in the real value of its $26 trillion in inflation-exposed liabilities. Netting out the US Federal Reserve’s holdings of long-term Treasuries brings the figure down to 9% of GDP.

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