Servicing government debt: The impact of rising interest rates

Interest rates are at historically low levels, both in the European Union and worldwide. For the euro area, a reason for low market interest rate levels is the accommodative monetary policy of the European Central Bank (ECB), which endeavours to increase inflation levels. Most of the time, central banks have to fight inflationary tendencies, but recently inflation was almost non-existent in the euro area, even leading to occasional dips into deflation. For some time, inflation was very far from the ECB’s 'below but close to 2%' aim.

With clear indication that inflation is picking up, an end to the accommodative monetary policy may be in sight. Should this impact long-term interest rates for government bonds, then it might lead to detrimental effects for governments. An increase in interest rates is generally thought to harm public finances, as the servicing of debt becomes more onerous.

This briefing shows that the increase in interest rates does not immediately and fully translate into higher costs for the state, as debt management strategies were put into place that will effectively reduce the short- and medium-term impact on the state’s coffers. However, in the long term, governments cannot escape the effects of market interest rate increases. It could lead to an increase in overall debt, and in certain cases might result in the neutralisation of past fiscal consolidation efforts.

Author: Christian Scheinert