Higher deficits cause inflation

It is a long-established fear among bond investors and economists that a country that runs higher budget deficits will eventually suffer from higher inflation in order to indirectly ‘default’ on its debt. We have seen that in action for much of 2026 in long-term bond markets. But a study by Jonathan Hazell and Stephan Hobler showed how fast this happens in the real world.

They wanted to know if one can trace the link between deficits and future inflation in single events. Of course, that means their study is not conclusive, only suggestive, but it still is a fascinating insight into how financial markets work, in my view.

They realised that the shift in political control from the Republicans to Democrats in 2020 not only rested on Joe Biden winning the Presidential election, but crucially on the Democrats taking control of the Senate. If they did so, they would have full control of both Congress and the White House, making it much easier for them to pass large stimulus packages to fight the pandemic. And because US politics is on a knife’s edge, it all hinged on the Georgia Senate election runoff. At the time of the runoff, Democrats had won 48 of the 100 seats in the Senate. If Democrats won both Georgia Senate seats, they would gain control of the Senate.

Before the runoff, different investment banks estimated that the Democrats would support a stimulus package in the order of $900bn on top of what had already been agreed in bipartisan bills (in the end it was about a trillion), so the stakes were high.

To cut to the chase, they found that bond markets, inflation swaps and dividend futures all adjusted in real time as the runoff unfolded. Here is how inflation expectations for 2022 (two years after the election) changed on the day of the Georgia runoff.

Change in 2-year forward inflation expectations

Based on a series of different analyses, they estimate that a one percentage point increase in the budget increased 2-year ahead price level expectations by about 0.19 percentage points. The result is that the deficit shock accounted for about a third of the inflation increase in 2021-2022 (of course, that would later be topped by the supply chain disruptions and the energy shock).

So, if we look at the deficits of the US, Japan, and many European countries today, it is clear that markets will reflect these in their inflation expectations in real time and that the impact of announcing higher deficits is quite large.