The Perils of Narrowing Fiscal Spaces

Do large fiscal deficits constrain the central bank’s response to inflation? If so, when? Local projections suggest that they do, particularly when inflationary pressures originate from supply shocks. Market real interest rates rise following oil-supply news shocks when fiscal space is ample but fall when it is narrow, consistent with markets anticipating weaker monetary tightening under fiscal pressure. We formalize this mechanism in a nonlinear general-equilibrium model with limited fiscal responsibility. The government stabilizes debt in the long run but resists rapid fiscal adjustment in the short run. When debt accumulates too quickly, it pressures monetary policy to limit rate increases, creating a state-contingent ceiling on the policy rate. As fiscal space narrows and the volatility of inflationary supply shocks rises, agents expect this constraint to bind more often, raising inflation expectations, trend inflation, and upside inflation risk. The model accounts for much of the rise and fall of U.S. trend inflation between 1965 and 1990 and interprets the post-pandemic rise in inflation as reflecting a greater risk that fiscal constraints bind amid narrower fiscal space and heightened supply-shock volatility.