The Inflationary Risks of Rising Federal Deficits and Debt

Today, the United States faces an unsustainable debt trajectory. By end of the next 10 years, the Congressional Budget Office (CBO) projects America’s debt-to-GDP ratio will approach 120% under current law, surpassing the prior record reached in 1946 in the wake of World War II. If expiring tax policies are extended without offsetting deficit reduction, debt would end the decade even higher.  Given this moment of heightened consumer price sensitivity and fiscal crossroads in the policy, the interplay between debt & deficits and inflationary pressures merits renewed scrutiny.

For decades, low and stable inflation has served as a bedrock of economic policy in advanced economies. This has been a long, hard-learned lesson. From the hyperinflation traumas of the Weimar Republic to the stagflation shocks of the 1970s to the global pandemic inflation, policymakers have been reminded time and again that price stability is not merely a technocratic objective on paper but a prerequisite for sustainable growth, equitable resource allocation, and public trust in economic institutions.

This paper argues that elevated federal debt increases the risk of inflationary pressure through several channels in both the short- and the long-term. Some are familiar and conventional mechanisms, such as short-run aggregate demand. Other channels include crowding-out of capacity investment, amplifying fiscal dominance concerns, and amplifying inflation expectations.

At its core, inflation can act as a stealth tax on economic certainty. When prices rise unpredictably, households face a dual burden: first, the erosion of their nominal incomes, and second, heightened uncertainty about future purchasing power. Lower-income households bear these uncertainty costs disproportionately, as they allocate larger shares of their budgets to non-discretionary items like food and housing—categories less flexible for substitution and particularly vulnerable to supply shocks, though it is not clear that low-income households always bear more of the actual costs of inflation.

Equally corrosive is inflation’s impact on decision-making frameworks. When businesses and consumers cannot distinguish relative price changes from economy-wide trends, resource allocation grows inefficient. Firms delay investments, households hoard goods, and lenders demand higher risk premiums—a dynamic starkly visible during the 1970s “Great Inflation,” when annual U.S. PCE price growth averaged 6.6%, versus 2.2% over the 1960s.¹ Research shows that higher inflation volatility can detract from growth, especially among countries with records of high inflation and low-credibility central banks.

Modern central banking in advanced countries has been shaped by the lessons of past inflationary crises. This evolution has taken many forms in the post-World War II decades, including the adoption of explicit inflation targeting or price stability frameworks, the gradual enshrining of political independence, and, more recently, the expansion of monetary policy toolkits to include unconventional actions like quantitative easing and forward guidance. As recently as 2023, all but six central banks globally explicitly prioritized low inflation, often codified in law. As discussed later, the rise of central bank credibility and anchored inflation expectations has shifted the trade-offs between debt and inflationary pressure.²

The relationship between public debt and inflation has been a central macroeconomic debate for decades. This review synthesizes empirical and theoretical insights into short- and long-run mechanisms linking debt to inflation.

Short-Run Mechanisms: Demand Shocks, Supply Chains, and Central Bank Missteps

In the short-run, debt adds to pressure from the interplay of Keynesian demand dynamics and temporary supply-side constraints. The pandemic was only the latest example of this economic story. One global comparative study, Jordà and Nechio (2022), concluded that while both deficits and inflation rose globally during the pandemic, the marginal fiscal actions by the United States in 2020 and 2021 and their effects on demand accounted for 3 percentage points of inflation by the end of 2021, though other advanced economies’ cumulative pandemic inflation began catching up with the US in 2022. CEA (2023) concluded that while supply-side issues were a major inflationary driver in their own right, they also interacted with the extraordinary global fiscal impulse, heightening the direct inflationary effects of fiscal policy. These shocks fed into heightened inflation expectations among both households and businesses.

Long-Run Channels: Expectations Anchoring and Crowding-Out

Over extended horizons, debt sustainability hinges on inflation expectations and fiscal-monetary coordination. Elevated debt-to-GDP ratios amplify crowding-out risks in the neoclassical framework: the possibility that growing government debt ties up an ever-greater share of private capital over time, raising interest rates and reducing investment. CBO generally assumes each additional percentage point of debt-to-GDP adds 2 basis points to the US 10-year Treasury yield. While directionally this is a well-established finding in the economic literature, as a long-term effect the point estimate is highly uncertain. Moreover, other factors weigh on interest rates as well; some, like demography, have been otherwise putting downward pressure on them. A smaller capital stock over time leaves a country more vulnerable to future supply chain shocks, which can raise inflation volatility. This is a particular risk given the rising uncertainty around future climate events, which have the potential to cause substantial supply-side damage and add to price pressure.

In regimes without central bank credibility, debt levels influence inflation expectations through fiscal dominance channels as well. (Fiscal dominance is the risk that debt and deficits reach a point where the government and central bank can no longer control inflation.) When investors perceive fiscal unsustainability, they demand higher inflation premiums, particularly in economies with short-maturity debt structures. In advanced economies like the United States, such effects are muted due to stronger institutional credibility on the part of the central bank. Note, however, that even in the best-case scenario, this just means that in advanced economies the trade-off runs through higher interest rates rather than higher inflation. Hence, throughout this paper, we more precisely refer to the trade-off in the context of the United States in terms of inflationary pressure, since the Federal Reserve in practice has to impose a cost from inflationary pressures through raising interest rates.

Some economists worry that persistent unsustainable deficits elevate fiscal dominance risk even in advanced economies, if lawmakers start putting political pressure on central banks to keep interest rates low to contain debt service costs.

Emerging markets offer an opportunity to study the direct trade-off between debt and inflation, often without the institutional complexities of a strong central bank. Studies find that dollarized debt and inflation-targeting regime adoption critically moderate economic outcomes. Emerging markets without inflation targeting experience persistent expectation de-anchoring after debt shocks. High initial debt compounds these effects. The nature of the shock can also matter. For example, Valencia et al. (2023) demonstrates that supply-driven inflation shocks in EMs raise debt-to-GDP ratios by eroding primary balances and spiking borrowing costs, whereas demand-driven shocks (e.g., stimulus-fueled growth) can reduce debt burdens if expectations remain anchored. This asymmetry underscores the peril of fiscal dominance in low-credibility regimes.

Estimating inflationary pressure from all of these various channels necessitates economic modeling. Different models of the economy at different horizons envision different mechanisms for debt to affect inflationary pressure and inflation. That’s because the relationship between public debt and inflation varies across economic paradigms. Please see the Appendix for a longer discussion.

The table above shows first how we would expect prices to evolve without a Federal Reserve response, and what that would mean for the purchasing power of household disposable income. Second and separately, it shows the cost in additional interest payments for mortgages if the Federal Reserve did respond. The simulations without a Federal Reserve shock show the result of an increase in the deficit and debt from a permanent 1%-of-GDP increase in federal transfers, without any reaction from the Federal Reserve. We chose a generic transfers shock because it would minimize any longer-run change in substitution effects and economic incentives resulting from federal policy (think of this shock as being equivalent to an on-going lump sum subsidy of ~$1,000 per adult per year in 2024$). This is not substantially different in magnitude from the effect of extending the individual provisions of the TCJA, whose cost through 2035 averages to an increase in debt-to-GDP of slightly more than 1 percentage point a year against current law. This is the appropriate way to model gross inflationary pressure from a fiscal shock. The shock boosts aggregate demand and, without intervention from the Fed, causes a feedback loop between actual inflation, inflation expectations, and wage growth. Note that the household income effects we report in the table above are equivalent inflationary or interest rate effects in isolation; they do not incorporate the broader negative economic effects of debt on real income nor do they include the positive effects of our illustrative policy.

Inflationary/Price Pressure Trade-Off

While the models have different results, all of them show a rise in prices without Federal Reserve intervention. For instance, Figure 1 below shows FRB/US (the Federal Reserve’s workhorse macroeconomic model) with core PCE prices at roughly 0.2 percentage points higher five years out. Think of this as the cumulative inflation effect over the first five years. As seen earlier in Table 1, one way to conceptualize the loss in consumer welfare from price increases is that it would be equivalent to average household disposable income being $330 lower per household per year in 2024$—note that this is separate from the positive income effects of the policy itself, which here is purely a mechanism chosen for rising debt.

We also look at the long-run impacts of a fiscal shock. As Figure 8 below shows, in a Solow Growth model (whose parameters are explained in the appendix), over 50 years the capital stock is more than 10% smaller, and real output is more than 3% lower.

We can also return to the FRB/US model, where we find that price pressures grow over time in the wake of the debt shock, reaching the equivalent of an-almost 10% higher price level after 30 years (Figure 9), the equivalent of a more-than-$16,000 loss in 2024$ per household (Table 1). Higher debt crowds out private investment, raising interest rates, lowering the capital stock, and depressing income. Three decades out, the private capital stock is 4% lower—a smaller effect than our Solow growth simulation but still substantial—and real gross national product is more than a full percentage point lower. That’s the equivalent of $4,000 per household less by 2055 in 2024$. Real household wealth is 2% smaller, a $24,000 loss in 2024$. Everyday interest rates rise as debt puts upward pressure on benchmark yields: conventional mortgage rates, for example, are 85 basis points higher in 30 years (in today’s context, that would add roughly $2,300 per year to the interest payment on the median-priced house). New car loan interest on the average 2025 loan would rise by $200 per year, and interest on the average 2025 small business loan would rise by $3,400 annually. 

The relationship between government debt and inflationary pressure is complex and multifaceted, with both short-term and long-term implications for economic stability and growth. The various models and simulations presented in this paper demonstrate that elevated federal debt can increase the risk of inflationary pressure through several channels, including direct demand effects, expectations feedback, reduced capacity and capital stock, and potential fiscal dominance concerns. While the magnitude of these effects varies across different models and time horizons, the consistent message is that persistent high levels of government debt can have significant consequences for price stability, interest rates, and overall economic performance.

The analysis also highlights the critical role of central bank credibility and fiscal-monetary coordination in mitigating the inflationary risks associated with high debt levels. As demonstrated by the FRB/US model simulations with Federal Reserve reaction, a credible monetary policy can help contain short-term inflationary pressures. But this still comes at the cost of higher interest rates. Moreover, the long-run simulations underscore the potential for substantial negative effects on capital accumulation, output, and living standards if debt levels continue to rise unchecked. These findings emphasize the importance of prudent fiscal management and the need for policymakers to carefully consider the long-term consequences of persistent deficit spending, particularly as the U.S. debt-to-GDP ratio approaches historic highs.