Fiscal Dominance Challenges Central Bank Independence Amid Rising Debt

Global economies are entering a new era of fiscal dominance, where central banks are increasingly pressured to align their monetary policies with fiscal needs. This shift is driven by the rapid expansion of government debt and rising borrowing costs, which challenge the independence of central banks and their primary mandate to control inflation.

This trend is most evident in the United States. The U.S. President has publicly urged the Federal Reserve to lower interest rates to ease the government's debt repayment burden. This direct political pressure has heightened market concerns about the Fed's future independence. Market reactions to recent U.S. inflation data have been unusual, with short-term bond yields falling due to rate cut expectations, while long-term yields have risen. This divergence suggests market anxiety over sustained government spending and potential political interference in monetary policy.

This dilemma is not unique to the United States. A Harvard University professor and former chief economist of the International Monetary Fund has stated that the world has entered a new era of fiscal dominance. This shift challenges the long-held principle of central bank independence and poses significant risks for investors, who are closely monitoring whether monetary policy will yield to fiscal demands.

The pressure on central banks stems from the ballooning government balance sheets worldwide. High-income countries are expected to borrow a record 170 billion dollars this year, 160 billion dollars in 2024, and 140 billion dollars in 2023. This makes it difficult for central banks, which have been trying to normalize their balance sheets after years of quantitative easing, to sell bonds and shrink their assets without increasing government borrowing costs, creating a policy conflict.

Investors are closely watching the Bank of England to see if it will significantly reduce its bond-selling plans in the next decision. The global head of macroeconomics at Amundi, a asset management company, noted that central banks face a dilemma: if financial conditions tighten due to fiscal policy, central banks cannot be seen as accommodating that policy. He believes the Bank of England will strongly resist fiscal dominance pressure. In the United Kingdom, long-term borrowing costs are particularly high, with 30-year government bond yields at 5.6%, near their highest level in 25 years. Even in Germany, known for its fiscal discipline, 30-year bond yields have risen to over 3%, the highest since 2011, due to government plans to increase borrowing for infrastructure updates and defense spending.

In the United States, market concerns about political interference are evident in various indicators. The yield spread between 2-year and 30-year U.S. Treasuries has widened to levels not seen since early 2022, reflecting market expectations of short-term rate cuts amid long-term inflation and debt risks. Analysts suggest that the market's unusual reaction to a mundane inflation report hints at potential outcomes if the White House takes steps to exert more control over monetary policy. The temporary appointment of a White House insider, known for advocating rate cuts, to the Federal Reserve Board has raised concerns about increasing fiscal dominance risks in the U.S.

A global rates strategist at Macquarie Group noted that futures markets have priced in five rate cuts by the end of next year, which seems high given the lack of economic recession. This suggests that some believe the Fed will become structurally dovish. In the long run, fiscal dominance could lead to extreme risks, such as a "debt death spiral," where governments borrow more to pay rising interest costs. If bond yields become too high, central banks may need to intervene by printing money and buying bonds to lower rates, ultimately leading to currency devaluation. This concern could weaken the value of major reserve currencies like the dollar and euro relative to gold, which has reached record highs this year. Additionally, market volatility makes it harder for governments to issue long-term bonds, potentially driving them towards riskier short-term debt and making their fiscal situations more vulnerable to interest rate fluctuations.