Great Dilution: The Global Impact of the US Inflation Shock on Sovereign Debt

Decades of low inflation led to widespread use of dollar-denominated financial instruments with fixed interest rates and long maturities. Unanticipated inflation dilutes the real value of these liabilities. We estimate this dilution to study the consequences of the recent US inflation shock on debt burdens. The United States Treasury, the largest issuer of dollar-denominated liabilities, gains between 6% and 20% of GDP (depending on the assumed size of the inflation surprise). Over $500 billion of these gains come at the expense of foreign creditors. The conventional wisdom holds that the increases in interest rates resulting from high inflation in the US will have a negative impact on emerging economies because of the reversal of capital flows and higher financing costs. However, this view misses the fact that higher US inflation also diminishes the burden of nominal fixed rate dollar-denominated sovereign debt issued by other countries. We find these gains to be substantial, which may help to explain why the current interest rate spike has not led to widespread sovereign debt crises.