Inflation Risk and Sovereign Spreads

We document that the co-movement of inflation and domestic consumption growth fluctuates over time. We argue that the co-movement of inflation and domestic consumption growth affects debt pricing and debt dynamics. In particular, a positive co-movement of inflation and consumption makes returns on government bonds negatively correlated with domestic consumption: this lowers risk premia on nominal domestic debt while making the debt more risky for the government. We construct a simple model of nominal domestic government debt incorporating an explicit default decision and an exogenous inflation risk to assess the overall effect of the inflation process on risk premia, probability of explicit default and equilibrium borrowing costs. Our findings have implications for the debate on the costs and benefits of joining a monetary union.