Higher deficits cause inflation

A recent study by economists Jonathan Hazell and Stephan Hobler has revealed the swift reaction of financial markets to changes in government budget deficits. Their research indicates that higher budget deficits can lead to increased inflation in a relatively short period of time.

The study focused on the link between budget deficits and future inflation, analyzing how quickly these effects manifest in the real world. While their findings are not conclusive, they provide valuable insights into the workings of financial markets.

The study examined the impact of the political shift from Republican to Democratic control in 2020, specifically the Democrats gaining full control of Congress and the White House. This shift was largely due to the Democrats winning the Georgia Senate runoff election. The outcome of this election was crucial, as it enabled Democrats to pass large stimulus packages to combat the pandemic.

The researchers discovered that bond markets, inflation swaps, and dividend futures all adjusted in real-time as the runoff unfolded. These adjustments reflected the changing inflation expectations for 2022, two years after the election. The study found that a one percentage point increase in the budget deficit led to an increase in 2-year ahead price level expectations by approximately 0.19 percentage points.

In conclusion, the deficit shock accounted for around a third of the inflation increase observed in 2021-2022. Although other factors, such as supply chain disruptions and energy shocks, also played a role, it is evident that markets quickly adapt their inflation expectations when faced with changes in government spending. In today's climate, with high deficits in the US, Japan, and many European countries, markets will reflect these deficits in their inflation expectations, highlighting the significant impact of announcing higher deficits on inflation.