Systemic Risk as a Transmission Mechanism: How Fiscal Imbalances Shape Inflation Dynamics

This paper studies a risk-based transmission mechanism linking fiscal and external imbalances to inflation dynamics. The mechanism operates through an economy-wide systemic risk state---capturing sovereign risk premia, policy uncertainty, and labor-market stress---that firms gradually incorporate into prices under nominal rigidities. Using quarterly Indian data (2004--2023), I construct a latent systemic risk index via principal components and estimate a Vector Error Correction Model (VECM) to characterize long-run comovement and short-run predictive dynamics among inflation, systemic risk, and fiscal/external balances. In the baseline specification, deficits predict the systemic risk factor; the risk factor predicts inflation at 4--6 quarter horizons; and the direct deficit--inflation predictive relationship attenuates once systemic risk is included, a pattern consistent with a risk mediation channel. Under a benchmark timing orthogonalization, systemic risk shocks account for about 28--35\% of medium-horizon inflation forecast error variance (8--12 quarters), exceeding the contribution of direct deficit shocks. In pseudo out-of-sample forecasting (from 2018Q1), risk-augmented models improve inflation forecasts relative to Phillips-curve and deficit-augmented benchmarks (about a 13\% RMSE reduction at four quarters in the baseline). The results provide evidence consistent with deficit-conditional inflation threshold findings: growth-consistent inflation may vary endogenously with the systemic risk environment shaped by fiscal and external positions.