Inflation and the Fiscal Limit

We use a rational expectations framework to assess the implications of rising debt in an environment with an unknown ‘fiscal limit.’ The fiscal limit is defined as the point where the government no longer has the ability to further expand its existing debt stock, so either fiscal or monetary policy must change to stabilize debt. We give households a joint probability distribution over the various policy adjustments that may occur, as well as the unobserved fiscal limit. One policy option that stabilizes debt is a passive monetary policy, which generates a burst of inflation that devalues the existing nominal debt stock. The probability of this outcome places upward pressure on inflation expectations and poses a substantial challenge to a central bank pursuing an inflation target. The upward bias that creeps into inflation expectations is more pronounced under high debt levels and high degrees of uncertainty surrounding the fiscal limit.