Fiscal risk shocks trigger stagflation, depress equities, BIS

A new working paper from the Bank for International Settlements estimates that fiscal risk shocks generate stagflationary dynamics. These shocks lead to rising inflation, temporary industrial production increases followed by declines, and falling equity prices across twelve economies.

Unpacking fiscal risk shocks

A new working paper from the Bank for International Settlements (BIS) estimates the macroeconomic and financial effects of fiscal risk shocks.

The authors developed a novel identification strategy using daily sovereign and safe corporate bond yields from twelve economies.

Their model, a Bayesian VAR, isolates shocks that raise sovereign bond yields while lowering yields of the safest corporate bonds, capturing investor rebalancing away from government debt.

These fiscal risk shocks generate stagflationary dynamics: inflation and inflation expectations rise on impact, while industrial production increases only temporarily before declining persistently.

Sovereign yield curves steepen, exchange rates depreciate, and equity prices fall.

These effects are significantly stronger when monetary policy remains accommodative, leading to persistently negative real interest rates, and when sovereign risk premia are already elevated.

Monetary policy's amplifying role

The study highlights that fiscal risk shock effects depend on monetary policy response and initial sovereign risk.

Accommodative monetary policy amplifies inflation and subsequent output decline.

In countries with elevated sovereign risk, inflation and inflation expectations respond more intensely and persistently.

The paper emphasizes financial markets' role in transmitting fiscal stress via sovereign risk premia, portfolio rebalancing, exchange rates, equity valuations, and the yield curve.

These findings underscore monetary credibility and fiscal space.

Validation tests confirm the identified shocks align with major fiscal events and are unanticipated.

Beyond the textbook models

This paper offers vital empirical evidence for fiscal risk transmission, moving beyond theoretical models.

It serves as a sharp warning: fiscal imbalances directly destabilize inflation and output, especially with accommodative monetary policy.

The findings critically underscore the deep link between fiscal discipline, central bank credibility, and financial stability, demanding integrated policy action.