The United Kingdom and Eurozone face high risk of fiscal dominance among developed economies, while such risks are lower in the United States of America, according to an economist.
“While we are a long way off central banks in developed economies directly financing governments, we could increasingly see central banks being constrained in what they do by the fiscal situation, such as having to modify their plans for quantitative tightening (QT). This is most likely in the UK and euro-zone,” Vicky Redwood, Senior Economic Adviser at Capital Economics said in a note.
Fiscal dominance implies a situation where a central bank needs to hold interest rates low to keep the government’s borrowing costs manageable, compromising its ability to control inflation.
Monetary financing, where central banks finance the government directly and permanently, is an extreme form of fiscal dominance, often seen in emerging markets. Another manner of fiscal dominance is so-called financial repression, which refers to measures that artificially boost demand of government bonds and keep bond yields lower.
After the pandemic hit in early 2020, central banks across the world slashed interest rates to record lows and purchased unprecedented amounts of government debt to buffer economies from the shock.
However, over the last several months, they have been raising rates in a bid to curb red-hot inflation that threatens medium term economic prospects.
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In the UK, the central bank has intervened in the bond markets in the past few weeks to calm investors after the government announced a mini-budget that shocked the bond market.
The measures taken by the Bank of England so far do not qualify as fiscal dominance, but this could be the thin end of the wedge, Capital Economics’ Redwood said.
A central bank could end up in the situation where it is faced with a choice of raising interest rates to meet its inflation target or keeping interest rates lower to mitigate financial stability risks.
Therefore, it might be wise to give central banks more discretion to prioritise whatever objective they deemed most important at the time, the research house said.
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Meanwhile, the risks of fiscal dominance are lower in the US as the deficit has been falling and there is evidence of inflationary pressures subsiding.
“With the US Fed likely to be one of the first central banks to be loosening policy again, there is less chance of fiscal and monetary policy having to work in opposite directions,” the economist said.