In theory, high debt levels should make monetary tightening more effective at curbing inflation, yet new research indicates that changes in the composition of that debt may counteract any increased rate sensitivity due to heavy debt loads.
According to a new staff working paper from the Bank for International Settlements (BIS), historically high private debt levels should mean that demand is more sensitive to higher interest rates.
In other words, central bankers should get more bang for their buck when raising rates to combat inflation.
“High private debt makes aggregate demand more sensitive to tighter monetary policy through several channels,” it said.
For one, higher rates translate into larger debt service costs, which weighs on household spending.
These costs also fall more heavily on lower-income households that spend more of their income — so higher rates hit spenders harder than wealthier savers.
“High debts imply larger financial vulnerabilities, strengthening the impact of tighter monetary policy,” the paper said.
Yet shifts in the composition of debt in the years since the financial crisis may blunt the impact of higher rates, researchers cautioned — meaning it may take longer for rate hikes to work.
“Following a decade of low interest rates, the shares of variable-rate and short-term debt for households and [non-financial corporations] have fallen, which limits the pass-through of policy rate hikes, reduces the flow effect of tighter monetary policy and increases its transmission lags,” the paper said.
So, in the end, the fact that debt loads are high may not make central bankers’ jobs any easier after all.
“[The changing composition of debt] arguably counteracts the higher sensitivity of aggregate demand to monetary policy stemming from elevated debt levels, so that the impact of tighter monetary policy will take more time to be fully transmitted,” it added.