The inflation impact of fiscal stimulus in Europe

Europe’s fiscal policy is changing. Germany will deploy a €500bn infrastructure fund over the next twelve years (that’s 12% of German GDP, mind you) and exempt defence spending from the debt brake. Across the EU, Ursula von der Leyen is trying to get a €800bn (4.3% of EU GDP over four to five years) ReArm Europe Plan over the line. Naturally, investors are starting to worry about how much inflation this fiscal stimulus will create.

Thus, the ECB's recent analysis of the link between fiscal stimulus and inflation is very timely and can provide us with an anchor for what to expect. Christina Checherita-Westphal and Tom Pesso built a model for the Eurozone and its member countries covering 1999 to 2022. In this model, they can assess the dynamic nonlinear interactions between fiscal stimulus, inflation, government debt levels, interest rates, and the output gap.

The good news (sort of) is shown below. Headline inflation in the Eurozone rises by about 0.2% three to four years after a fiscal stimulus of 1% of GDP. The stimulus packages for the EU and Germany are much larger than that, so there will be more inflation, but the buildup will be gradual and will not come as a shock as in 2022. Hence, businesses have time to adapt.

Impact of fiscal stimulus of 1% of GDP on Eurozone inflation

Source: Checherita-Westphal and Pesso (2024)

Even so, we must expect headline inflation to be around 0.5% higher five years from now and about 1% higher in ten years. This is why I always say that 3 is the new 2 for central bank inflation targets. Sooner or later, I think central banks will have to accept that they should aim for 3% average inflation, not 2% as they did in the past.

However, the inflation push from the fiscal stimulus is not the same in all circumstances. Countries with higher debt levels should experience a stronger increase in inflation as bond markets react to more fiscal stimulus with higher bond yields, which in turn increases the debt costs for governments and, hence, financing costs for businesses, etc.

Plus, it weakens the Euro, creating additional import price inflation from goods that are traded in US Dollars, for example. Higher interest rates can counterbalance this inflation effect and the weakness of the Euro to keep inflation under control.

If you add it, which factor will win, and how much will inflation rise?

The chart below gives an overview of the key results. After four years, inflation will likely be 0.2% higher if the government deploys a fiscal stimulus of 1% of GDP. Core inflation is likely to be about 0.1% higher than before. For countries with debt/GDP-levels above average (c.70% in the sample they study, so Germany is below that, but France is above it), the inflation increase rises to about 0.4%.

Given the planned fiscal stimulus's size, that really worries me.

This is where the ECB can help. For countries with interest rates above average, the higher cost of debt reduces demand quickly and thus creates a powerful offset. A fiscal stimulus of 1% of GDP followed by rate hikes to above-average levels effectively reduces inflation four years after the stimulus.

Impact of fiscal stimulus of 1% of GDP on Eurozone inflation depending on macro environment

Source: Checherita-Westphal and Pesso (2024)

The upshot is that we can mitigate and even eliminate the inflationary impact of the stimulus packages if we are willing to accept higher interest rates. Or we can try to insist on low interest rates, in which case we will have to live with substantially higher inflation.