Discretionary fiscal policy, fiscal credibility and inflation risk premium

Abstract

Studies seek to identify the determinants of the inflation risk premium. Nevertheless, the literature investigating the effects of fiscal variables on the inflation risk premium is scarce. This study is the first to investigate the effects of discretionary fiscal policy and fiscal credibility on the inflation risk premium. Using a modern Fisher equation, we calculate the inflation risk premia to four different maturities as well as to the first principal component of these maturities. In order to provide robust results, we use two different fiscal credibility indicators, and two different fiscal impulse indicators to capture the use of discretionary fiscal policies. The analysis considers the Brazilian case for the period between January 2005 and June 2018. The findings suggest the adoption of discretionary fiscal policies increases the inflation risk premium. The estimates also indicate that fiscal credibility improvements reduce the inflation risk premium and, these improvements are able to mitigate the adverse effect of discretionary fiscal policies on the inflation risk premium. In addition, a dynamic analysis through impulse-response functions obtained from VAR estimates reveal that the inflation risk premium is more sensitive to improvements in fiscal credibility than in monetary credibility. The dynamic analysis also reveals that responses of the inflation risk premium last longer for improvements in fiscal credibility than for improvements in monetary credibility.