Fiscal Surprises and Rising Prices: IMF Warns of Inflation Risks in Latin America

Expansionary fiscal policy in Latin America, especially when unexpected, raises inflation through higher demand, rising expectations, currency depreciation, and increased risk premiums. sipea2025144 The IMF warns that credible fiscal and monetary frameworks are essential to prevent these shocks from undermining price stability.

The International Monetary Fund (IMF), drawing on research from institutions including the Bank for International Settlements (BIS), the National Bureau of Economic Research (NBER), and leading academic centers, issues a clear warning in its latest Selected Issues Paper: expansionary fiscal policy across Latin America, especially in Colombia, poses real and immediate inflationary risks. Governments in the region are trying to support growth and respond to social needs after the pandemic, but the IMF cautions that widening deficits are not benign. They feed directly into inflation, influence expectations, elevate risk perceptions, and pressure exchange rates in ways that complicate already delicate monetary policy decisions.

Fiscal Policy Meets Inflation Head-On

Colombia’s case illustrates the dilemma vividly. During 2024–25, policymakers adopted a more expansionary fiscal stance even as inflation hovered above the central bank’s target range. This creates a policy tug-of-war: fiscal stimulus injects demand into an economy that monetary policy is simultaneously trying to cool. The IMF’s multi-country analysis, covering Brazil, Chile, Colombia, Mexico, and Peru between 2010 and 2024, shows a consistent pattern: unexpected fiscal deficit shocks raise inflation quickly and persistently. A deficit surprise equal to 1 percent of GDP lifts headline inflation by about 0.35 percentage points in the same year, with the effect remaining strong one year later. Short-term inflation expectations react even more sharply, rising by around one full percentage point, suggesting that firms and households rapidly adjust their price outlooks when governments deviate from expected fiscal paths.

Demand, Expectations, and Currency Pressures

The IMF identifies three reinforcing channels through which fiscal expansion generates inflation. First, stronger public spending widens the output gap by approximately 0.38 percentage points, tightening capacity constraints and pushing prices upward, especially for non-tradables. Second, the shock alters inflation expectations: even if central banks are credible over the long term, markets may doubt their willingness to maintain high interest rates when public debt servicing becomes more costly. The third channel is financial: in emerging markets, fiscal surprises tend to weaken currencies rather than strengthen them. The paper shows that exchange rates depreciate by about 1 percent following deficit shocks, a reflection of rising investor concerns rather than capital inflows. Correspondingly, sovereign credit default swap spreads increase by 6 to 11 basis points, indicating a measurable rise in perceived risk. These pressures make imports more expensive, feeding back into headline inflation.

Debt Shocks Amplify the Risk

Unexpected increases in public debt also contribute significantly to inflation. A one-percentage-point increase in the debt-to-GDP ratio pushes inflation up by roughly 0.25 percentage points, and the pressure persists into the following year. But the real danger emerges when debt levels are already high. When countries’ debt ratios exceed 55 percent of GDP, inflation expectations rise more sharply, risk premiums spike, up to 50 basis points on five-year CDS spreads, and exchange rate depreciation can reach double-digit territory. In such environments, fiscal slippage triggers more severe confidence shocks, magnifying the inflationary impact. The IMF stresses that even countries with strong monetary frameworks remain vulnerable if fiscal deterioration becomes too pronounced.

Credibility as the Anchor

Despite these risks, the study finds that long-term inflation expectations remain broadly anchored, suggesting that institutional credibility is still intact across the region. However, the rapid adjustment of short-term expectations and the sensitivity of financial indicators highlight how fragile this credibility can become under fiscal strain. The analysis shows that results hold regardless of where economies are in the business cycle and that fiscal contractions, when unanticipated, reduce inflation just as fiscal expansions raise it. The overarching message is unmistakable: predictable, credible fiscal frameworks are essential to safeguarding price stability. For Colombia and its regional counterparts, the lesson is that fiscal policy is not just about balancing budgets, it is a central part of the inflation story. Avoiding unexpected slippage, maintaining transparent rules, and coordinating carefully with monetary authorities remain critical to steering inflation back toward target in a challenging global environment.