Central banks under mounting debt pressure

Executive summary

Mounting government debt and persistent fiscal pressures are rekindling concerns that central banks may shift from monetary independence to fiscal dominance. Successive global shocks have pushed public borrowing to record highs across major economies, complicating efforts to maintain price stability. While institutional guardrails mean this shift remains a medium-term risk rather than an immediate reality for the US and euro area, vulnerable economies such as the UK and Japan face heightened market sensitivity. Ultimately, delaying fiscal consolidation narrows central bank flexibility, increasing the likelihood that fiscal burdens will eventually influence monetary policy decisions.

Rising debt and the risk of fiscal dominance

To cushion the impact of these shocks, government borrowing has surged to record highs, posing new challenges for central banks in their pursuit of price stability. The recent spike in inflation across the US and Europe, coupled with mounting fiscal pressures, has reignited concerns about the risk of fiscal dominance. Some economists have questioned whether central banks will retain the flexibility to raise interest rates or shrink their balance sheets as needed to fulfil their mandates. These concerns point to a potential shift from monetary independence – where central banks can pursue price stability free from fiscal pressures – to fiscal dominance, where central banks prioritise financing the government’s borrowing needs, often by keeping interest rates low or expanding the money supply.

In the United States, rising deficits and debt servicing costs – combined with explicit political pressure on the Federal Reserve to lower rates – have raised concern that the country could be drifting toward fiscal dominance. Deficits are projected to remain above 6% of gross domestic product (GDP) over the coming decade. Public debt-to-GDP has surpassed 100% for the first time in decades, and net interest expense as a share of GDP has doubled in the past five years.

A classic example of US fiscal dominance dates back to World War II, when the Federal Reserve capped interest rates to facilitate war borrowing – a policy that contributed to a postwar inflation spike. The 1951 Treasury-Fed Accord subsequently established central bank independence, separating government debt management from monetary policy. More recently, Federal Reserve Chair Kevin Warsh has argued that fiscal dominance – or, as he prefers to call it, “monetary dominance” – is already in place, with the Federal Reserve having proactively subsidised government borrowing by maintaining a large balance sheet and suppressing interest rates. In his view, the Federal Reserve has not merely responded to fiscal pressure but has actively enabled it.

Fed independence amid closer Treasury ties

We expect the Fed will retain independence in making interest rate decisions, as the institutional guardrails seem intact after recent challenges. However, closer coordination between the Federal Reserve and the Treasury on the central bank’s balance sheet appears likely, as suggested by Warsh’s proposal for a “new accord” aimed at shrinking the balance sheet while allowing for lower rates. The Federal Reserve could enhance transparency around the likely size and composition of its balance sheet in the coming years, including plans to shorten the average maturity of its securities holdings. The Treasury, in turn, could clarify its intentions for the maturity distribution of its debt issuance. The Federal Reserve might, for instance, shift its portfolio towards Treasury bills while the Treasury Department simultaneously increases T-bill issuance. Whether labelled fiscal or monetary dominance, a closer relationship between the two institutions seems probable.

This raises questions about the Federal Reserve’s independence in setting monetary policy, and whether the US could face a crisis akin to the UK’s “Liz Truss moment.” While the term premium is structurally higher due to rising debt, widening deficits and persistent inflation, the dollar’s unique status as the world’s reserve currency – together with the depth of US capital markets – affords exceptional fiscal leeway. Although a shift away from the dollar in the global currency order, so-called dedollarisation, is a long-term trend, it is unlikely to materialise in the near future, as no single currency or basket currently offers a viable alternative.

Guardrails against fiscal dominance in the euro area

In recent years, the risks of fiscal dominance in Europe have intensified. In response to the pandemic and the war in Ukraine, European governments implemented a wide range of fiscal measures to mitigate the negative impacts on income, growth and employment. These actions led to a significant increase in government debt-to-GDP ratios.

During the pandemic, the European Central Bank (ECB) maintained a low-interest-rate environment and launched an extensive asset purchase programme – the Pandemic Emergency Purchase Programme (PEPP) – which indirectly supported fiscal expansion and alleviated concerns about debt sustainability by reversing the spike in spreads triggered by the pandemic shock. This raised questions about the ECB’s ability to fulfil its mandate of price stability.

However, the rapid interest rate hikes following the surge in inflation in 2022, along with the introduction of the Transmission Protection Instrument (TPI), have eased fears of fiscal dominance. Furthermore, ECB quantitative tightening (QT) has been a non-event, and the ECB continues to gradually shrink its balance sheet. For now, fiscal dominance in the euro area remains more of a risk than a reality. European fiscal rules provide a framework to prevent excessive public debt, and government pressure to keep interest rates low is much less intense than in the United States.

Fiscal dominance pressures mounting in the UK

Preventing fiscal dominance requires a truly independent central bank, underpinned by a sustainable and credible fiscal framework, to ensure that inflation does not become the primary tool for reducing public debt. The UK provides a relevant example, where fiscal dominance may already be exerting a significant influence. Despite government efforts to stabilise public finances and demonstrate fiscal discipline, persistently high inflation, sluggish growth and a more restrictive monetary policy from the Bank of England (BoE) have increased uncertainty over the country’s debt trajectory.

This has contributed to greater bond market volatility, as investors remain unconvinced by the government’s fiscal measures. In addition, the indemnity the BoE currently receives from the UK government on its quantitative easing bond portfolios makes its fiscal independence even more questionable. Should fiscal pressures intensify further, fiscal dominance could become more of a reality for the BoE.

China and Japan: focal points of Asian fiscal dominance

In Asia, public debt has risen sharply over the past two decades, driven by significant fiscal responses to major shocks: the global financial crisis, the Covid pandemic and the inflation surge that followed Russia’s invasion of Ukraine. More recently, oil shocks stemming from Middle East conflicts – which have had a pronounced impact on Asia – have prompted further government spending. Looking ahead, public debt in the region is expected to keep climbing on the back of slower economic growth, higher interest rates and rising expenditures linked to ageing populations.

While higher public debt often correlates with stronger fiscal dominance, several mitigating factors are at play. Many Asian countries have adopted fiscal rules – such as numerical ceilings on deficits or debt, alongside medium-term fiscal frameworks – which support fiscal discipline, though these rules are sometimes relaxed during major shocks. Central bank independence in Asia has generally strengthened since the Asian financial crisis, narrowing the gap with the US. That said, market concerns persist in some economies, including Japan, Indonesia and Thailand. In addition, most Asian economies have adopted inflation-targeting frameworks, which have helped contain price pressures.

Fiscal dominance risks across Asia are far from uniform. In China, fiscal dominance is evident in the use of off-budget fiscal policy, supported by credit easing from the Chinese central bank – a reflection of the country’s distinctive policy framework. Although a broad paradigm shift toward a rate-based monetary policy has reduced fiscal dominance somewhat, it remains a feature of the system. In Japan, where public debt is exceptionally high, fiscal dominance concerns have intensified under Prime Minister Sanae Takaichi’s “proactive” fiscal stance and dovish monetary tilt, which have raised medium- to long-term fiscal risks and pressured the yen, complicating the Bank of Japan’s normalisation path. While recent statements have sought to emphasise “responsible” fiscal policy, fiscal dominance concerns are likely to persist, given Takaichi’s focus on growth, security and household support.

Fiscal risks as a medium-term challenge

Overall, while the fiscal situation has clearly worsened over the past two decades, governments have so far managed to kick the can down the road. As long as markets remain willing to finance high and rising public debt at a reasonable cost, the shift from monetary independence to outright fiscal dominance is likely to remain a medium-term risk rather than an imminent reality. Nonetheless, in periods of market stress, the weakest links, such as the UK or Japan, are likely to experience the sharpest increases in sovereign bond yields. Moreover, the longer fiscal consolidation is postponed, the more constrained central banks’ room for manoeuvre will become, increasing the likelihood that fiscal considerations will eventually weigh more heavily on monetary policy decisions.