Why big fiscal deficits and low inflation can coexist

Abstract

▀ The surge in government debt caused by ballooning fiscal deficits is a necessary response to the coronavirus crisis. But we doubt this will lead to a burst of inflation in the advanced economies (AEs), let alone a debt crisis. ▀ Our fiscal forecasts assume AEs’ budget deficits averaged 20% of GDP or so in Q2. However, our deficit forecasts point to a sharp narrowing thereafter and for public debt as a share of GDP to peak in 2021. ▀ The risks around this forecast skew firmly towards deficits remaining wide, reflecting the balance of risks around our GDP forecasts and the possibility that governments allow some fiscal slippage. ▀ A slower narrowing of fiscal deficits than we forecast wouldn't automatically lead to a period of above‐target inflation. Indeed, we wouldn't be surprised if larger‐than‐expected deficits were associated with weak inflation. ▀ High levels of corporate debt and weak labour markets raise the risk of private sector retrenchment ahead. In that case, large and sustained fiscal deficits may be needed to fill the vacuum and prevent GDP and inflation from falling. As has been the case in Japan over the past 25 years, large deficits over coming years could be associated with weak GDP growth and below‐target inflation. ▀ If economies begin to overheat but governments keep fiscal policy loose, inflation could, of course, pick up. But central bank tightening would offset it. We believe the risk of sustained inflation overshoots is limited unless monetary policy were made subservient to governments’ own objectives. And we think the risk of central banks losing independence remains slim.