COVID-19 has supplied the catalyst for a secular change in the role of central banks. Providing governments with ammunition to fight the virus is now the overriding goal, and this means keeping bond yields pinned close to zero for the foreseeable future.
The Changing Role of Central Banks
Throughout history, central banks have performed three main roles: providing low and stable inflation (price stability); safeguarding financial stability; and helping governments pay their bills (monetization). The importance of these different roles varies over time, and they often conflict. In the 30 years prior to the global financial crisis (GFC), for example, most central banks focused exclusively on price stability. But that approach led to the biggest financial crisis since the Great Depression, so central banks added financial stability to the mix (nominally, at least).
Direct monetization has fallen out of fashion in recent decades—with the odd, noteworthy exception (i.e., Venezuela, Zimbabwe). But in the past, central banks have often helped governments pay their bills, particularly during wartime. So it’s not surprising that they’ve stepped in to give countries the financial firepower to confront COVID-19 without triggering a self-defeating increase in bond yields.
A Bad Time for a Crisis
Public sector balance sheets weren’t in great shape coming into the coronavirus crisis, and they’re soon going to look an awful lot worse. At the end of last year, the combined government debt of the G7* group of large industrial nations stood at almost 120% of gross domestic product (GDP), higher than at the end of either the first or second world wars. This year, with budget deficits set to move sharply higher and output likely to collapse, that number will probably rise to something like 140% of GDP.
There was a time—not that long ago—when that sort of number would have been considered unsustainable. At the beginning of Europe’s sovereign-debt crisis, Greece’s debt-to-GDP ratio was 146%. Such elevated debt ratios are no longer considered unsustainable because interest rates are so low. But just how low do interest rates need to be for the major developed economies to remain solvent?
What Level of Interest Rates Keeps Debt-to-GDP Stable?
To explore this point, we calculated debt-stabilizing interest rates (DSIRs) for select developed economies. This simple calculation estimates the average cost of funding needed to keep the debt-to-GDP ratio stable. It’s based on three variables: the level of government debt, the size of the primary budget balance (excluding interest payments) and projected nominal GDP growth. For illustrative purposes, we use the International Monetary Fund’s 2021 forecasts for government debt and the primary balance, and our own projections for nominal GDP growth (Display).