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 US Treasury, the largest issuer of dollar-denominated liabilities, gained 6% of GDP from the inflation surprise of 2021 and 2022 (a third of which was paid by foreign creditors), a number that can escalate to 20% depending on how long it takes for inflation to return to the 2% target. For emerging markets the conventional wisdom holds that the increases in interest rates resulting from high inflation in the USA will have a negative impact 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.