Household Beliefs about Fiscal Dominance

Impact of information treatments on debt expectations and inflation expectations (in percentage points)

Debt-to-GDP ratios have increased substantially in advanced economies since the onset of the Covid-19 pandemic, raising concerns that these elevated levels of public debt may pose a threat to price stability. An increasing debt-to-GDP ratio can become inflationary when a central bank, confronted with a substantial public debt, is less willing to raise rates sufficiently to fight inflationary pressures, as such an increase could endanger public debt sustainability. This phenomenon is referred to as fiscal dominance. The risk of fiscal dominance can influence households’ inflation expectations, which can subsequently affect current inflation (through their impact on wages and aggregate demand). In this paper, we use individual survey data to provide evidence that a share of households have beliefs consistent with a fiscal dominance mechanism. Testing whether the data support this relation is challenging since it requires an exogenous shock to debt-to-GDP ratio, a causal response of inflation expectations to this shock, and a measure of perceived stretched fiscal resources. We propose the use of survey data to meet these requirements and we design a customized survey administered to a representative sample of about 6,000 German households in November 2021. 

First, we elicit individuals’ perceptions of how much the euro-area fiscal capacity is stretched by asking them about the likelihood of a sovereign default of at least one euro-area member occurring in the coming years. We also elicit individuals’ views on whether fiscal capacity will constrain monetary policy by asking them about the likelihood of the European Central Bank (ECB) keeping interest rates low to help fiscal authorities roll over their debt. We find that about 75 percent of households in the sample believe that either of these scenarios is likely or very likely. Moreover, the respondents do not perceive the two scenarios as mutually exclusive: About 65 percent of households report that both scenarios are likely or very likely. 

Second, we examine whether, consistent with the fiscal dominance view of inflation, news signalling an increase in public debt leads to higher inflation expectations. A key challenge in identifying the reaction of expectations to fiscal news is measuring an exogenous fiscal shock and a causal reaction of inflation expectation to that shock. We address this issue by conducting a randomized controlled trial using information treatments on fiscal variables. We provide randomly selected groups of respondents with public information from the European Commission about future debt-to-GDP ratios projected for Germany, France, and Italy over a three-year horizon. In addition, we consider two treatments providing information about the interaction between monetary and fiscal policies. We then ask individuals about their euro-area debt-to-GDP ratio expectations and German inflation expectations, allowing us to identify the effects of each treatment on both variables. We find that information on public debt in France and Italy significantly increases the expected euro-area debt-to-GDP ratio by approximately 13 percentage points (Fig. 1a). In addition, we find that the French and Italian debt treatments, which significantly increase debt expectations, also lead individuals to significantly increase the average inflation rate they expect over the next five to ten years. The impact is quantitatively modest, about 8 basis points (Fig. 1b). Conversely, the other treatments have small and non-significant impacts on debt-to-GDP and inflation expectations.

Third, we investigate how these aggregate effects vary across individuals with different views on the euro-area fiscal space. Focusing on treatments informing about the French and Italian fiscal situations, we find that individuals who think that a default in the euro area is very likely increase their debt-to GDP ratio by about 11 percentage points and their inflation expectations by 16 basis points. For these households, an increase in debt cannot be fully funded, and, consistent with the fiscal dominance mechanism, this lack of fiscal space implies some partial need to inflate debt away. 

In a last section, we rationalize these empirical results with a New Keynesian model in which agents have heterogeneous beliefs about whether the economy will move from a monetary dominance regime to a fiscal dominance regime. We find that fiscal news can exert inflationary pressures even when the central bank follows an optimal policy. This heterogeneity introduces a policy trade-off, as the inflationary impact of such beliefs requires a negative output gap to be offset. 
 

Keywords: Inflation Expectations, Fiscal and Monetary Policy, Heterogeneous Beliefs, Randomized Control Trial, Survey Data.

Codes JEL : E31, E62.