How fiscal concerns shape inflation expectations
The paper by Andrade, Gautier, Mengus, Mönch, and Schmidt investigates how households’ beliefs about fiscal space influence their expectations of inflation, specifically focusing on the concept of fiscal dominance—where elevated public debt affects price stability. The authors designed and administered a survey to approximately 6,000 German households in November 2021. Treatments included information about debt levels in Germany, France, and Italy, ECB quantitative easing, and a statement from the Bundesbank president. Finally, they rationalized their empirical findings by developing a New Keynesian model incorporating heterogeneous beliefs about fiscal dominance.
Key findings
- Beliefs about fiscal capacity:
– Approximately 80% of respondents believed that either a euro-area sovereign default or ECB constraints on raising interest rates were likely or very likely
– These beliefs varied by individual characteristics (income, assets, age, gender, location, political leaning)
– Households expecting a default anticipated higher inflation and lower growth
- Effects of fiscal news on expectations:
– Information about French and Italian debt significantly increased expected euro-area debt-to-GDP ratios (by about 13 percentage points)
– These treatments also led to higher inflation expectations (by about 8 basis points)
– German debt, ECB purchases, and Weidmann statement treatments had smaller, mostly non-significant impacts
- Heterogeneous responses based on fiscal space beliefs:
– Households believing a euro-area default was very likely, increased inflation expectations by about 16 basis points after French/Italian debt information
– Households viewing default as less likely showed non-significant inflation expectation increases (about 4 basis points)
– This confirms that households perceiving more constrained fiscal space view debt increases as more inflationary
- Model implications:
– Fiscal news can exert inflationary pressure even when the central bank follows optimal policy
– Heterogeneity in beliefs creates a policy trade-off, as offsetting the inflationary impact requires a negative output gap
– The central bank may optimally tolerate some inflation due to the real costs of completely stabilizing prices
Household Beliefs about Fiscal Dominance
Authors: Philippe Andrade, Erwan Gautier, Eric Mengus, Emanuel Mönch, Tobias Schmidt
From: Federal Reserve Bank of Boston, Banque de France, HEC Paris, Frankfurt School of Finance and Management, Bundesbank
How public debt undermines monetary policy
Bigio, Caramp, and Silva introduce, in this paper, an important new framework for understanding persistent inflation in high-debt environments, particularly relevant in the aftermath of the COVID-19 pandemic. The authors identify a phenomenon they call “sticky inflation,” where attempts to reduce inflation through interest rate hikes can backfire in economies with high debt levels. This occurs because higher interest rates initially reduce inflation through decreased aggregate demand but these same rate hikes increase government debt servicing costs. As debt accumulates, the public anticipates future inflationary financing to manage this debt, these inflation expectations feed back into current prices, causing inflation to resurge. Bigio et al. develop a New Keynesian model with two distinct phases:
Fiscal-expansion phase:
– Government runs primary deficits
– A potential switch to the second phase looms with some probability
– Monetary policy operates independently
Inflationary-finance phase:
– Monetary authority temporarily allows higher inflation to stabilize debt
– After a fixed period, inflation and output stabilize
The mere anticipation of a possible switch to the inflationary-finance phase alters current economic dynamics by linking debt levels with inflation expectations. This anticipation appears in both the Euler equation and Phillips curve as endogenous demand and cost-push effects.
Optimal policy insights
The paper upends conventional wisdom about monetary policy responses:
- Optimal real interest rates may need to be lower than suggested by traditional models after fiscal shocks
- Hawkish central banks (those primarily concerned with inflation) might paradoxically need to be less responsive to inflation initially than dovish ones
- Front-loading inflation can be optimal to better manage debt trajectories and minimize long-term inflation pressures
Unlike standard New Keynesian models where rate hikes control inflation with temporary output costs, here aggressive rate hikes can create a permanent cycle of debt accumulation and inflation. As a result, traditional inflation-fighting strategies may be ineffective or counterproductive in high-debt environments.
Sticky Inflation: Monetary Policy when Debt Drags Inflation Expectations
Authors: Saki Bigio, Nicolas Caramp, Dejanir Silva
From: UCLA, UC Davis, Purdue University
