From my boss, as reported by Market News International (no link available):
Although capable of inducing an interest rate rise, government deficits are not automatically inflationary, contrary to popular belief, said Cleveland Federal Reserve Bank President Sandra Pianalto on Monday.
"Deficits can indeed be a problem," Pianalto conceded in a speech at an economic conference in Milan. "A government finances budget deficits by selling debt to its own citizens and to foreigners. Real interest rates could rise as government deficits crowd out business and consumer investment."
"But," she continued, "despite what popular commentaries might suggest, there is no need for deficits to be inflationary. The prospect of inflation arises only if the central bank tries to resist the rise in real interest rates, thereby keeping its policy rates too low and inadvertently easing monetary policy."
This is where the central bank's commitment to price stability plays a critical role, Pianalto argued, even if the deficit's impact on economic growth can't always be neutralized.
"But the more credible the central bank's commitment to price stability, the less likely that an inflation premium will be built into market interest rates," she said. "The best way for an economy to adjust to outside shocks and government deficits is in an environment of low inflation and stable inflation expectations."