We used simulations to analyse the impact of the recent episode of high inflation on Belgium’s public finances. Specifically, we compared the budgetary impact under the macroeconomic frameworks of the NBB’s December 2021 and June 2023 macroeconomic projections. We assumed that differences in deflators, interest rates and economic activity between these two sets of projections could largely be attributed to – or in any case were associated with - the unexpected surge in inflation.

Inflation started to rise sharply in the euro area in mid-2021. This surge was driven by the strong post-pandemic economic recovery and rising energy prices, which were further exacerbated by Russia’s invasion of Ukraine. In Belgium, inflation exceeded 10% in 2022, a level unseen since the 1970s. Such an inflation surge has significant economic consequences: it erodes household purchasing power, puts corporate profit margins under pressure and forces central banks to tighten monetary policy.

In these unusual circumstances, the question arises as to the impact of high inflation on Belgium’s public finances. This question is particularly relevant given the challenge of making Belgian public finances healthier in the coming years and reversing the structurally upward debt dynamics.

It is often claimed that inflation is good for public finances. Revenue, including from consumption taxes, for instance, is boosted by rising consumer prices. Policymakers tend to maintain that this additional revenue can be used to finance government measures to offset the loss of household purchasing power. Moreover, inflation leads to an immediate fall in the debt-to-GDP ratio, as rising prices push up the denominator.

However, other factors linked to inflation are unfavourable for public finances. For instance, public expenditure also increases, especially when expenditure items are indexed automatically, as is the case in Belgium with social benefits and the wages of civil servants. In addition, inflation also raises nominal interest rates, all the more so when the central bank tightens policy, thereby resulting in higher interest payments on public debt.

An interesting question is whether a rise in inflation is associated with higher or lower economic activity.

The origin and nature of inflation play an important role in determining its impact on public finances. For instance, imported inflation, such as that resulting from rising energy prices, has a more unfavourable impact on economic activity and the relative price of domestic goods than inflation stemming from growing domestic demand.