Bank for International Settlements working paper models how high public debt can cap rate hikes and create inflationary bias

The Bank for International Settlements (BIS) published a working paper analysing how elevated public debt can endogenously constrain monetary policy tightening by raising the fiscal cost of fighting inflation. Using a nonlinear New Keynesian framework, it finds that proximity to a fiscal limit can weaken the interest rate response to inflation and generate an inflationary bias even when fiscal policy remains Ricardian and government debt is fully backed by future primary surpluses. The model introduces a state-dependent ceiling on the policy rate derived from a debt-to-GDP limit, so that when debt is high, rate hikes increase debt service costs and depress growth, narrowing fiscal space and forcing the central bank to tighten less than implied by its notional rule. Inflationary cost-push shocks are highlighted as particularly problematic because they raise inflation while slowing output, making the fiscal limit more likely to bind and amplifying inflation dynamics, with countercyclical fiscal policy further tightening the constraint in downturns. In a calibration aligned with US post-1960 data, the paper reports a risky-steady-state inflation rate of about 2.1% versus a 2% target, with the fiscal limit binding around 8% of the time, largely driven by supply shocks; a slightly tighter fiscal limit materially increases the estimated inflationary bias and the frequency of binding episodes. The paper also discusses how, in extreme demand-driven downturns, the fiscal constraint could become more restrictive than the zero lower bound, leaving the central bank facing a choice between money creation to purchase excess government debt or accepting an outcome consistent with fiscal dominance. It flags future work to assess the empirical relevance of fiscal limits and to extend the framework to richer policy dynamics.