The Impact of Loose Fiscal Policy on Global Interest Rate Policy and Investment Strategy

The interplay between loose fiscal policy and central bank credibility has become a defining feature of global economic governance in the 2020–2025 period. As governments deployed unprecedented stimulus measures to counteract pandemic-induced recessions and post-pandemic supply chain disruptions, central banks faced a dual challenge: maintaining inflationary expectations while preserving their policy autonomy. This tension has reshaped interest rate dynamics and investment strategies, with far-reaching implications for markets and macroeconomic stability.

The Erosion of Central Bank Control

Loose fiscal policy, characterized by expansive government spending and tax cuts, has increasingly outpaced the ability of central banks to anchor interest rates. A 2025 analysis by Aswath Damodaran underscores that macroeconomic fundamentals—particularly inflation and real GDP growth—have emerged as stronger drivers of treasury rates than direct central bank interventions [1]. For instance, despite the Federal Reserve’s three rate cuts in 2024, market interest rates rose, reflecting investors’ recalibration of risk-free rates based on inflation and growth expectations. This phenomenon challenges the traditional view of central banks as sole arbiters of interest rates and signals a shift toward a regime where fiscal dominance—a situation where governments pressure central banks to monetize deficits—risks undermining policy credibility [3].

The International Monetary Fund (IMF) has sounded alarms about the sustainability of global public debt, which is projected to exceed $100 trillion in 2024, with risks skewed to the upside [1]. Such debt levels amplify the likelihood of fiscal slippages, forcing central banks to navigate a precarious balance between supporting growth and curbing inflation. In the U.S., the Fed’s 2025 policy review, initiated to address post-pandemic challenges, highlights the need to recalibrate its framework to account for the intertwined dynamics of fiscal and monetary policy [2].

Central Bank Credibility: Metrics and Global Variations

Central bank credibility, a cornerstone of effective monetary policy, is increasingly tested by fiscal overreach. Research by Catherine L. Mann emphasizes that credibility hinges on transparency, independence, and the ability to anchor inflation expectations [2]. In economies with robust institutional frameworks, such as Japan, macroprudent policies have maintained credibility despite elevated debt levels. Japan’s inflation, now near the Bank of Japan’s 2% target, reflects confidence in its policy consistency, driven by wage growth and structural reforms [1].

In contrast, emerging markets face heightened vulnerabilities. A 2025 study on Indonesia reveals that monetary policy effectiveness in promoting inclusive growth requires multidimensional metrics, including institutional quality and digital infrastructure [4]. Weak fiscal transparency in such economies exacerbates inflationary risks, as seen in cases where governments lack independent fiscal institutions to constrain deficits. A 2024 paper on fiscal transparency further notes that transparency reduces sovereign borrowing costs in developing economies, underscoring its role in bolstering central bank credibility [2].

The Eurozone offers a mixed picture. While the European Central Bank (ECB) has maintained its inflation-targeting credibility, its 2025 strategic review reflects the need to adapt to evolving economic realities, including the risks of fiscal dominance in member states with weaker fiscal governance [1].

Market Implications and Investment Strategies

The recalibration of central bank credibility has profound implications for investment strategies. Bond markets, once seen as a safe haven, now demand diversification beyond U.S. Treasuries. For example, the U.S. dollar weakened in Q2 2025 amid trade concerns and a widening budget deficit, prompting investors to rebalance portfolios toward emerging market debt and inflation-linked securities [4].

Equity markets, meanwhile, have shown resilience. Despite initial volatility from Trump-era tariff policies, the S&P 500 rebounded as trade rhetoric eased, supported by strong corporate earnings and accommodative monetary policy [4]. However, tariffs pose a drag on growth, particularly in sectors like durable goods, where price pressures persist [1].

For investors, the key lies in hedging against inflationary shocks and fiscal uncertainty. A 2025 market outlook recommends overweighting sectors insulated from trade wars (e.g., technology) and underweighting cyclical industries vulnerable to tariff-driven cost inflation [1]. Additionally, alternative assets such as real estate and commodities offer inflationary hedges, while high-quality corporate bonds provide yield without excessive duration risk.

Conclusion

The era of loose fiscal policy has redefined the relationship between central banks and markets. While central bank credibility remains a critical anchor for inflation expectations, its erosion through fiscal dominance threatens to destabilize global financial systems. Investors must adapt by diversifying portfolios, prioritizing transparency, and hedging against macroeconomic imbalances. As the Fed and other central banks refine their frameworks, the interplay between fiscal and monetary policy will remain a pivotal determinant of both interest rates and investment returns.

Source:
[1] IMF Fiscal Monitor, [https://www.imf.org/en/Publications/FM]
[2] Speech by Catherine L. Mann, [https://www.bankofengland.co.uk/speech/2025/august/catherine-l-mann-panellist-at-conference-commemorating-100th-anniversary-founding-banco-de-mexico]
[3] The Inflationary Risks of Rising Federal Deficits and Debt, [https://budgetlab.yale.edu/research/inflationary-risks-rising-federal-deficits-and-debt]
[4] Analysis of Monetary Policy in Indonesia, [https://www.researchgate.net/publication/394314454_Analysis_of_The_Effectiveness_of_Monetary_Policy_in_Promoting_Inclusive_Economic_Growth_in_Indonesia_A_Comparative_Study_For_The_Period_2015-2025]