Discount Rates, Debt Maturity, and the Fiscal Theory

Since the Great Recession, large-scale purchases of long-term government bonds have become essential for central banks around the world. There has been keen interest in understanding how these operations affect other areas. This is particularly true when countries are under fiscal pressure—from deepening deficits and surging government debt—and when short-term interest rates are near the effective lower bound.

We examine how changes to monetary and fiscal policy influence government portfolio risk from debt maturity operations. We theorize that accounting for bond risk premiums allows the government portfolio to affect inflation. This would be the result only in a policy setting where the central bank responds passively to inflation and the fiscal authority responds weakly to the debt level. This is a possible characterization of the policy mix in the United States after the Great Recession.

To quantify this theory, we use a New Keynesian model to match important features of the term structure of interest rates, debt maturity and macroeconomic fluctuations of the US economy. Generating a realistic nominal term premium is particularly important for measuring portfolio risk from debt maturity shocks. A shock that matches the impact of quantitative easing programs on average debt maturity lowers expected inflation and reduces output on impact. These effects persist in the following quarters.