How Fiscal Choices Shape Prices: ECB Report Links Government Spending to Inflation

The European Central Bank, in collaboration with academic research institutes, has turned its analytical lens on one of the most pressing questions in today’s economic debate: does fiscal policy meaningfully influence inflation in the euro area, or does monetary policy remain the ultimate driver of prices? This question, long the subject of theoretical dispute, has gained sharp urgency in the wake of unprecedented fiscal interventions during the COVID-19 pandemic and the energy crisis that followed Russia’s invasion of Ukraine. With billions of euros in public transfers, subsidies, and investment programmes rolled out across the continent, the ECB’s economists and their partners set out to measure whether fiscal actions were directly stoking inflation or merely coinciding with overlapping shocks. Their latest working paper offers one of the most comprehensive explorations yet, covering more than two decades of euro area evidence.

Shifting Boundaries Between Policy Tools

The study begins by reflecting on the traditional separation of roles: fiscal policy for stabilisation, distribution, and growth; monetary policy for inflation control. Yet recent years have blurred this neat division. The massive fiscal stimulus packages of 2020–21 coincided with supply bottlenecks and labour market tightness, producing the steepest rise in euro area inflation since the single currency’s creation. While the timing made many observers suspect a direct fiscal-inflation link, the authors stress that correlation is not causation. Their goal is to isolate “fiscal shocks”, unexpected deviations in spending or taxation, and trace their impact on inflation. To this end, they employ local projection techniques on quarterly data from 1999 onwards, drawing on national accounts and fiscal statistics across member states. By distinguishing expenditure measures from revenue measures and filtering out cyclical variations, they build a framework capable of separating genuine fiscal impulses from background noise.

Spending, Taxes, and Modest Inflationary Effects

The findings suggest that fiscal policy does matter, but the effects are modest in scale and strongly dependent on context. On average, an unexpected increase in government spending nudges inflation upward, with the impact peaking around one year later. The size of this effect is small, typically around 0.1 to 0.2 percentage points, far below the magnitudes often suggested in political debate. Revenue-side shocks, such as tax cuts, produce less consistent results. They can stimulate household demand and exert some price pressure, but their effect is weaker and less predictable than direct spending increases. Fiscal consolidations, achieved through spending restraint or higher taxes, show the opposite pattern: a slight downward effect on inflation, though not dramatic. The paper’s graphs illustrate how these impulses rise and fade, underscoring that fiscal policy is not a blunt weapon against inflation but a subtle instrument whose influence depends on timing and design.

State Dependence and International Contrasts

Perhaps the most striking insight is the idea of “state dependence.” The impact of fiscal shocks on inflation is larger when the economy is under strain or when monetary policy is constrained, such as at the zero lower bound for interest rates. In those situations, fiscal actions play a stronger role in shaping inflationary dynamics, filling the void left by limited central bank firepower. This was most visible during the pandemic, when fiscal packages met a situation of limited monetary manoeuvrability. Charts in the report reveal how the same fiscal shock produces larger inflation responses in low-rate environments than in normal times. International comparisons drive the point home: in the United States, where fiscal rules are looser and coordination with monetary policy less structured, spending shocks generate larger inflationary effects. The euro area’s stricter fiscal frameworks appear to dampen these effects but cannot eliminate them.

Designing Smarter Fiscal Policy for the Future

The research also digs into sectoral nuances. Public investment emerges as a category with low short-run inflation costs and high long-term benefits, stimulating supply capacity and productivity. By contrast, spending on wages or transfers, measures that quickly boost disposable income, carries a more immediate inflationary footprint, especially if it triggers higher wage demands in the private sector. The message is clear: not all fiscal expansions are equal, and the design of measures matters as much as their scale. A euro channelled into infrastructure has a different macroeconomic legacy than a euro spent on salaries or subsidies.

For policymakers, the implications are sobering but pragmatic. Fiscal policy is not the main engine of inflation in the euro area, where the ECB’s monetary framework still dominates. Yet it cannot be dismissed, particularly in extraordinary times when governments are most inclined to act. Uncoordinated expansions risk complicating the ECB’s task by adding demand pressure just as monetary policy is tightening. Conversely, targeted, temporary, and well-structured fiscal measures can complement monetary policy, cushioning vulnerable groups without embedding higher inflation expectations. The decentralised nature of fiscal authority in the euro area adds another layer of complexity, making coordination more challenging but also more essential.

As Europe looks ahead to new pressures on public finances, from the climate transition to defence spending, the paper issues a timely caution. The inflationary consequences of fiscal activism will hinge not only on how much governments spend but also on what they spend it on and the broader economic context in which these measures are deployed. In calm periods, fiscal policy’s influence on inflation may remain muted. In turbulent times, however, it can become a decisive part of the story. The ECB’s partnership with research institutes underscores a broader lesson: fiscal choices are never neutral for price stability, and their interplay with monetary policy will shape Europe’s path through the shocks of the coming decade.