Fiscal deficits and inflation risks: the role of fiscal and monetary policy regimes

Revised version published in June 2023.

BIS Working Papers  |  No 1028  | 
07 July 2022



The massive wave of fiscal stimulus unleashed by governments in the wake of the Covid-19 pandemic has sparked an intense debate about the inflationary consequences of current fiscal policies. Is higher inflation after the pandemic a fiscal phenomenon? Will the need to manage high public debt levels pose a risk to price stability?


To investigate the contribution of fiscal deficits to the recent increase in inflation, we estimate an open-economy Phillips curve augmented with the fiscal balance using data from 21 advanced economies over four decades. Apart from the econometric specification, what distinguishes our analysis from previous research is that we carefully consider the fiscal-monetary policy regimes in place. Furthermore, we examine the effects of higher deficits not only on average inflation but also on the "tail risks" to future inflation outcomes.


We find that the strength of the deficit-inflation link crucially depends on what kind of fiscal-monetary policy regime is in place. A higher deficit is least inflationary under a "monetary-led" regime, defined as a regime in which the fiscal authority acts prudently to stabilise public debt and the central bank is highly independent (and faces strong legal limitations on its ability to lend to the public sector). By contrast, the greatest inflationary effect is found under a "fiscally led" regime, defined as a regime in which fiscal policy is profligate and the central bank is constrained only in a limited way from lending to the public sector. Higher deficits increase the inflation risks on the upside (ie the probability of high inflationary outcomes), and these effects are larger in the fiscally led regime. Finally, given the size of the fiscal stimulus and other macroeconomic variables observed in 2020, forecasts from our model suggest that the high inflation of 2021 and 2022 appears more consistent with a fiscally led rather than a monetary-led regime.


Using data from a panel of advanced economies over four decades, we show that the inflationary effect of fiscal deficits crucially depends on the prevailing fiscal-monetary policy regime. Under a fiscally led regime, defined as a regime in which the government does not adjust the primary balance to stabilise debt and the central bank is less independent or puts less emphasis on price stability, the average effect on inflation of higher deficits is found to be up to five times larger than under a monetary-led regime. Under a fiscally led regime, higher deficits also increase the dispersion of possible future inflationary outcomes, especially the probability of high inflation. Based on forecasts from our model, the high inflation experienced by many countries during the recovery from the Covid-19 pandemic appears more consistent with a fiscally led regime than a monetary-led regime.

JEL classification: E31, E52, E62, E63.

Keywords: fiscal deficit, inflation, fiscal policy regime, monetary policy regime, monetary policy independence.