Bank for International Settlements publishes working paper finding fiscal risk shocks can trigger stagflationary dynamics

The Bank for International Settlements has published a working paper by Denis Gorea, Ding Xuan Ng and Fabrizio Zampolli examining how fiscal risk shocks affect financial markets and the wider economy across 12 economies. Using a new market-based identification method built from daily sovereign and safe corporate bond yields, the paper finds that when investors question fiscal sustainability and demand higher sovereign yields, borrowing costs rise, exchange rates depreciate, equity prices fall, inflation and inflation expectations increase, and output receives only a temporary boost before moving into a more persistent contraction. The identification strategy isolates episodes in which sovereign yields rise while the yields of the safest corporate bonds fall, capturing investor reallocation away from government debt toward private safe assets. On average, the paper finds that sovereign yield curves steepen and goods and services prices remain elevated for about one year, while the medium-term drag on activity reflects tighter financial conditions. The effects are materially stronger when monetary policy remains accommodative and real interest rates stay negative, and when sovereign risk premia are already elevated. The publication states that the views expressed are those of the authors and do not necessarily reflect those of the Bank for International Settlements or its member central banks.