Fiscal Implications of Interest Rate Normalization in the United States

Abstract

This paper studies fiscal implications of interest rate normalization from the zero lower bound (ZLB) in the United States. At the ZLB, the decline in the tax revenue and the real bond price drives up government debt. During normalization, the interest payment continues to stay higher than the path without the ZLB. Despite the recovery of output and tax revenue, government debt can grow further. Against the yardstick of ability to pay, interest rate normalization is unlikely to pose an immediate threat to debt sustainability at the current net federal debt level of 90%-100% of GDP. If the net federal debt reaches 150% of GDP, however, sovereign default risk can rise more quickly. Also, a more active monetary policy during normalization can better anchor inflation expectations and generate a faster recovery in investment and output, helping slow debt accumulation relative to the path with a less active one.