Fiscal Implications of Interest Rate Normalization in the United States

Abstract

This paper studies the main channels through which interest rate normalization has fiscalimplications in the United States. While unexpected inflation reduces the real value ofgovernment liabilities, a rising policy rate increases government financing needs because ofhigher interest payments and lower real bond prices. After an initial decline, the realgovernment debt burden rises even with higher tax revenues in an expansion. Given thecurrent net debt-to-GDP ratio at around 80 percent, interest rate normalization leads to anegligible increase in the sovereign default risk of the U.S. federal government, despite amuch higher federal debt-to-GDP ratio than the post-war historical average.

Keywords: Economic growth, Business cycles, Capital income, Real interest rates, Interest rate increases, interest rate normalization, monetary and fiscal policy interaction, fiscal sustainability, non linear DSGE models, New Keynesian model, limit distribution, active rule, debt level, bond price, government debt

JEL Classification: E43, E52, E62, E63, H3, E01, G21, H83, H71