August fourteenth, two thousand twenty-five
《Fiscal Dominance vs. Monetary Dominance: 101》
Fiscal Dominance and Monetary Dominance: An Introductory Guide
Over the past few months, our content has continued to examine in depth how the world’s major economies, led by the United States, are shifting toward fiscal dominance. This assessment has also become one of the core frameworks we use to evaluate the trajectories of many assets. Today’s Notes returns to the starting point of this macro framework, filling in the basic contours of fiscal dominance to help everyone understand more clearly how this transition began.
One. Fiscal Dominance, Monetary Dominance, and the Nature of Inflation
Discussing fiscal dominance inevitably means discussing monetary dominance as its counterpart...
The nature of inflation is a social construct, in practice, high inflation often benefits highly leveraged entities while eroding savers’ real wealth. Inflation that remains above target for an extended period essentially reflects the greater influence exerted by government and private-sector borrowers over the central bank’s policy stance (put simply, inflation also represents the depreciation in the value of government and some private-sector liabilities relative to a basket of goods and services). This is a typical feature of “fiscal dominance.”
Therefore, Discussing fiscal dominance is essentially a matter of asking who has priority in policymaking (whether actively or passively), whether the central bank sets interest rate policy first or the government sets fiscal deficit policy first; in other words, which policy, in the logic of real-world behavior, places a stronger constraint on the other decision.
In immediate forecasting, shocks and cyclical factors are key, They directly affect intraday or daily trading logic. Immediate forecasting requires a bottom-up approach and very close tracking, examining the correlations among large amounts of real data. This approach is most accurate for forecasts over three to six months.
The top-down approach is the main direction of macro strategy, focusing on macro variables such as the unemployment rate, GDP, money supply, and inflation expectations.This approach has little relevance for forecasts over the next three to six months, but it can provide a medium- to long-term macro narrative... And it is this medium- to long-term narrative that determines the weekly trading logic that actually shapes price trends in the market. Whether fiscal dominance or monetary dominance prevails has a major influence on this medium- to long-term assessment.
Separating shocks and cyclical factors from trend inflation is a prerequisite for building an effective macro narrative.
Trend inflation stems from a divergence between the trends in aggregate demand and aggregate supply; fundamentally, it is the product of joint government and central bank policy. When liabilities are created and circulate far faster than goods and services are created and circulate, inflation is the only way to close this gap. When this gap is structural, trend inflation emerges. To maintain low trend inflation (for example, about 2% per year), it is necessary to avoid injecting too many such liabilities into the economy. Therefore, the conditions under which liabilities are created are crucial.
A simplified framework for assessment is:
1) Under monetary dominance, the central bank continues to honor its commitment to stabilizing inflation, while the fiscal authority adjusts future deficits to stabilize debt dynamics.. In this case, the fiscal imbalance is closed through higher taxes.
2) Under fiscal dominance, the central bank abandons its commitment to stabilizing inflation, and the fiscal authority does not adjust future revenues and expenditures to stabilize debt dynamics.. In this case, the fiscal imbalance is resolved through higher inflation, which automatically dilutes the real value of debt.
However, there is a third case: the central bank does not necessarily coordinate with the government in practice, which leads to a conflict in the policy mix. Against this backdrop, an unintended contest between monetary and fiscal dominance takes place，For example, this occurs when the central bank remains committed to stabilizing inflation while the government does not adjust the pace of future debt issuance to help stabilize debt dynamics. This situation is closer to the current policy environment in many advanced economies, including the United States.
Two. Monetary dominance
Since the 70s of the 20th century, monetary dominance has effectively been the market norm. During the period in which central banks gradually gained greater independence, financial conditions were determined exogenously by central banks. In this situation, governments take the financial conditions set exogenously by central banks into account when formulating fiscal plans. The logic is as follows:
1) If the fiscal deficit is too large (as noted above, this creates too much broad money), it will generate inflationary pressure, and the central bank will respond by tightening financial conditions (raising interest rates and/or reducing its holdings of public debt, that is, demonetization). This will raise the cost of future government bond issuance and increase the fiscal burden.Under these expectations, assuming the government cannot compel the central bank to maintain loose financial conditions over the long term, its rational choice is to implement fiscal tightening and avoid stimulating aggregate demand.
2) If the fiscal deficit is too small (as noted above, this creates too little broad money), it will generate deflationary pressure, and the central bank will respond by easing financial conditions (cutting interest rates and/or increasing its holdings of public debt, that is, monetization). This will increase the scarcity of future government bond issuance and reduce fiscal costs.Under these expectations, assuming the government knows the central bank will not exit loose financial conditions too early, its rational choice is to increase fiscal spending and rekindle demand to stimulate aggregate demand.
From the perspective of money creation, the scale of the government’s net debt issuance is kept at a level that ensures both slow growth in broad money and the achievement of its inflation target after the central bank sets interest rate policy exogenously.
Three. How monetary dominance shifts to fiscal dominance
Complete monetary dominance risks insufficient aggregate demand, and an overly rigid central bank introduces a deflationary bias. In the face of a major deflationary shock, monetary policy can encourage the government to increase spending by cutting interest rates. However, a genuine recovery requires the government to issue public debt on a large scale and increase the public debt/GDP ratio.
Even under these conditions, if the central bank chooses to maintain a strict inflation target, private entities will expect financial conditions to tighten rapidly once aggregate demand recovers. In that case, public support may still be insufficient.
In this scenario, the central bank’s “irresponsibility” (that is, allowing the price level to rise/an inflation overshoot) can bring about a more thorough and comprehensive rebound in economic activity. At the same time, an inflation overshoot will also lower the government’s debt/GDP ratio.The central bank’s temporarily sidestepping its statutory mandate means that a degree of mild fiscal dominance needs to be introduced in the short term to achieve a better outcome.
This is essentially the story of the United States in 2021.
The Federal Reserve’s revision and adoption of average inflation targeting in the summer of 2020 is a classic example of this kind of monetary-driven coordination. Rather than viewing inflation of 2% as a ceiling, FOMC began treating it as an average, thereby allowing inflation to exceed the target moderately. This enabled the government to drive the economic recovery more effectively.This was done by keeping interest rates extremely low for an extended period to support fiscal stimulus, with that government spending flowing directly into the economy and without being backed by a commitment to future fiscal surpluses.
The experience of 2020 showed that this approach was highly effective in the short term, but more inflationary over the medium to long term, because it meant the Federal Reserve’s structural stance would be more dovish and introduce a degree of inflationary bias.
After this tendency had run its course, the central bank should have taken over again. But the arrival of a new government threw off coordination between the central bank and the government, further creating a conflict in the policy mix.Against the backdrop of this conflict, an unintentional contest between monetary and fiscal dominance would emerge, while uncertainty over economic policy under Trump directly affected the central bank’s core decision-making logic for its assessments: data... This gave rise to passive fiscal dominance, In other words, it is not that the central bank has actively chosen to abandon its commitment to stable inflation; rather, it objectively no longer has the ability to make precise assessments or respond in advance, and that is exactly what is happening today.
Figure: Notes250801 “Agency Problems and Forward-Looking Behavior (with a Discussion of Employment Data)”
Finally, one addendum: why the euro area has in fact been the best example of monetary dominance for many years
In fact, many euro area countries have a long history of fiscal dominance, the euro area's peripheral countries generally have a pronounced inflationary bias, central banks in several countries are comparatively less independent vis-à-vis their national governments, while Germany is a classic case of central bank independence from the 70s through the 90s of the 20th century.
If we look at the compound annual growth rate of the price level for each decade, we can see a long-term divergence in inflation trends among euro area countries, with peripheral countries clearly tending toward higher inflation relative to Germany.
After the 2000–2010s, on the one hand, northern countries were unwilling to expand spending; on the other, the sovereign debt crisis of 2011-2013 forced inflation-prone peripheral countries to deleverage. Overall low leverage means that, even when interest rates rise, euro area public finances remain able to withstand the pressure as a whole, without relying on fiscal dominance to push rates down.
Moreover, as a monetary union, the euro area naturally has a strong monetary-dominance regime, mainly for two reasons:
1) The European Central Bank faces the finance ministries of 20 countries, and those ministries cannot influence the direction of monetary policy; this asymmetry gives the central bank an overwhelming advantage. 2) The ECB’s institutional design follows the Bundesbank model and gives it complete monetary independence, both in law and in practice. In fact, before the euro was introduced, the Bundesbank often threatened the government with rate hikes and tighter financial conditions; in the Nordic countries, there was also a strong aversion to inflation.
Within this framework, the euro area's potential risks stem more from financial fragmentation than from fiscal dominance, Overall leverage is low, but distributed very unevenly; the past inflationary bias has turned into public debt burdens and spread risks:
Germany, the Netherlands, and Austria have very strong fiscal safety margins, but a structural decline in private savings and an increase in domestic public spending over the long term could bring higher domestic growth and put upward pressure on interest rates outside the euro area.
France, by contrast, has a structural current-account deficit, high debt, and a lack of fiscal consolidation. Although it is supported by higher potential growth and its position at the core of Europe, this situation is unsustainable. Italy is similar: high sovereign debt leaves households and non-financial firms with low leverage, making productivity gains essential to avoid a sovereign repayment crisis...
In a crisis, especially an asymmetric one, the European Central Bank will not tolerate overall inflation overshooting its target. The crisis is therefore more likely to take the form of sovereign debt risk (deflation and forced deleveraging) than a currency-devaluation crisis (inflation/currency depreciation).
In other words, the peripheral countries traded an inflationary bias for a bias toward sovereign debt crisis risk.
If a country's government wants to increase spending, the ECB is not particularly concerned, but the private sector may demand higher interest rates because of debt problems in some countries, as in Italy (not because the policy mix is excessively stimulative, but because the debt burden is too heavy) and France (for reasons similar to those in the United States).
Of course, if the private sector charges excessively high and unreasonable risk premia on the public debt of some euro area members, that could also prompt the European Central Bank to slow its tightening cycle to avoid triggering a sovereign debt crisis. Overall, however, the ECB is indeed still less tolerant of an overshoot in overall inflation than central banks such as the Federal Reserve.
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2025.08.14
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