KEY TAKEAWAYS
- Fiscal policy (government spending and taxation) is one of the primary drivers of aggregate demand and thus inflation
- Expansionary fiscal policy (more spending, lower taxes) stimulates demand and tends to increase inflation
- Contractionary fiscal policy (spending cuts, tax hikes) reduces demand and tends to lower inflation
- The CPI relative to GDP growth is a key signal for interpreting fiscal policy’s inflationary impact
- In 2026, elevated US government deficits represent a persistent expansionary bias that supports inflation above the Fed’s 2% target
Fiscal Policy Definition
Fiscal policy, traditionally defined as the government’s spending and revenue policy, is one of the most important drivers of economic activity and inflation. It is the primary tool that governments use to stimulate or cool down the economy in order to achieve their policy objectives. The main objectives of fiscal policy are to stabilize the economy, stimulate economic growth, and promote economic and social equity. To these ends, governments use fiscal policy to influence aggregate demand and the price level.Expansionary fiscal policy is used to stimulate economic activity and encourage inflation.
Expansionary fiscal policy involves increasing government spending and decreasing taxes, thereby stimulating aggregate demand and encouraging people to purchase goods and services. This typically leads to an increase in the money supply and an increase in prices, resulting in inflation.Contractionary fiscal policy, on the other hand, is used to slow down the economy and reduce inflation.
This involves decreasing government spending and increasing taxes to reduce aggregate demand and slow down economic activity.📈 Key Insight: Fiscal and monetary policy can work in opposite directions — creating a “policy conflict” that is particularly relevant in 2026. When a government runs a large deficit (expansionary fiscal policy) while the central bank is trying to raise rates to fight inflation (contractionary monetary policy), the two forces partially offset each other. The net result is often higher interest rates for longer, as the central bank must work harder to offset fiscal stimulus. This is relevant for bond market positioning and for assessing long-duration equity valuations. See our investment framework for current fiscal and monetary signals.
The Impact of Fiscal Policy on Inflation
The impact of fiscal policy on inflation can be observed in economic data. The most important data for interpreting the effects of fiscal policy on inflation are the consumer price index (CPI) and the gross domestic product (GDP). The CPI measures changes in the prices of a basket of goods and services that are commonly bought by consumers, while the gross domestic product measures the total value of all goods and services produced in the economy. Data on these two indicators can help economists to interpret the effects of fiscal policy on inflation. For example, if the CPI increases relative to the GDP, then it is likely that expansionary fiscal policy has increased aggregate demand and led to an increase in inflation. Similarly, if the CPI decreases relative to the GDP, then it is likely that contractionary fiscal policy has reduced aggregate demand and led to a decrease in inflation.⚠️ Watch Out: Fiscal policy affects inflation with long and variable lags. Government spending programs can take 1–2 years to fully flow through the economy into prices, meaning investors who react only to current CPI data may already be behind the curve. Watch deficit projections and Congressional Budget Office forecasts alongside current CPI — the fiscal trajectory is as important as the current reading. Persistent structural deficits (as in the US in 2026) are a long-term inflationary anchor that limits how far inflation can fall even when the economy cools.
Investment Actions
These changes in inflation can then be translated into investment actions. For example, if the CPI increases relative to the GDP, then investors can choose to invest in assets that are sensitive to inflation, such as stocks and real estate assets, as these assets are likely to appreciate in the event of an increase in the inflation rate. In an expansionary fiscal environment, TIPS (Treasury Inflation-Protected Securities), commodities, real estate, and companies with strong pricing power tend to outperform. In a contractionary fiscal environment, long-duration bonds and growth stocks with high future earnings streams may benefit as inflation expectations fall.📊 Portfolio Takeaway
Monitor the US fiscal deficit trajectory alongside CPI data. In 2026, with a deficit above 6% of GDP and a structural spending bias, the fiscal backdrop supports “higher for longer” inflation — which argues for maintaining inflation-sensitive assets (energy, commodities, TIPS, real assets) in your portfolio alongside cash flow-positive equities with pricing power. Avoid long-duration bonds until fiscal consolidation is credible.
