- The increase in the government budget deficit, compared to the period before the war, contributed about 0.5–1 percentage points to the increase in inflation expectations.
Government expenditures were high in 2024, mainly due to the war. These expenditures led to a high deficit and a significant increase in public debt. Expansionary fiscal policy can lead to rising inflation through an increase in domestic demand, especially when there are supply constraints in the economy. A high government deficit can also lead to market assessments that the government will struggle to repay future debt through taxation or through spending cuts, an assessment that will also lead to higher inflation expectations.[1]
A box in the forthcoming Bank of Israel Annual Report examines whether an increase in the deficit environment is indeed perceived as inflationary in Israel. Focusing on inflation expectations rather than actual inflation allows for the identification of the deficit’s inflationary impact based on high-frequency data. Since inflation expectations influence actual inflation, the impact of a deficit increase on inflation expectations indicates a risk channel for rising inflation that is also related to fiscal policy.
[1] The fiscal theory of the price level )Cochrane, 2023) emphasizes the importance of responsible fiscal policy for maintaining price stability, as high government debt can lead to inflationary pressures through the public's perception that the value of the real debt will be eroded by inflation aimed at meeting obligations.