Reforming the Federal Reserve, Part 8: Preventing Fiscal Dominance

Still, this independence does not constitute a full separation between monetary policy and fiscal policy because all monetary policy actions have some fiscal consequences.² Moreover, the Fed’s monetary policy does not solely determine the economy’s rate of inflation, which is determined by, among other factors, interactions between both fiscal and monetary policy decisions. Policymakers should actively analyze these interactions rather than relying only on the Fed to keep prices stable.

Despite these interactions, monetary policy and the task of keeping inflation low and stable are under the mandated purview of the Federal Reserve. Under normal circumstances, the Fed does play the dominant role in managing price levels, but ultimately, maintaining stable inflation requires the central bank to work in conjunction with a responsible fiscal agent that facilitates good monetary policy. But an irresponsible fiscal agent that runs persistent deficits and does not sustainably manage the national budget can derail monetary policy. If this happens, the central bank can be forced to choose between keeping inflation low and preventing default on the national debt. Of course, in most such situations, the monetary authority usually abandons its price stability goals and instead uses monetary tools to lower the government’s interest payments.³ This situation, known as fiscal dominance, is liable to result in high inflation.

As we discussed in a previous paper in this series, the Fed’s operating framework now makes it easier to exploit the central bank through backdoor fiscal operations that avoid the normal appropriations process. This new framework makes the threat of fiscal dominance more real than ever. Congress can, and should, remedy this situation by requiring the Fed to abandon its current operating framework and follow rules-based monetary policy. In the absence of congressional action, the Fed can shield the economy from fiscal dominance by simply implementing good reform policies on its own: These include shrinking its balance sheet and following a transparent policy rule.

Put simply, fiscal dominance is a macroeconomic condition where fiscal policy (i.e., government spending, borrowing, and taxation) effectively dictates a country’s monetary policy rather than the other way around. It can arise when there is a coordination failure between a country’s monetary and fiscal agents, including instances of surprise fiscal expenditures that unexpectedly increase deficits and debt well beyond their existing trends.

To properly coordinate, the central bank must be active, and the fiscal agent must be passive. A central bank is active when it adjusts the target for the policy rate (in the US, this is the federal funds rate) to keep inflation low and stable; it is passive when it uses the policy rate to ensure that interest payments on outstanding government debt remain low. A fiscal agent is passive when it spends sustainably; it is active when it spends unsustainably with no clear aim of eventually balancing the budget.

There are four possible combinations of monetary and fiscal interactions.⁴ Two such outcomes are when both agents are active or both are passive. In such cases, economic theory predicts that the price level will be indeterminate—a situation where inflation could become unstable and unpredictable. These outcomes are unlikely to occur in advanced economies such as the US, where inflation expectations remain anchored, so the public usually ignores them.⁵

The scenario that most people are familiar with historically, though, is when the central bank is active and the fiscal agent is passive. Most economists agree that the US was under such a system from the mid-1980s through at least the financial crisis of 2008—a period characterized by low and stable inflation. A situation with a passive central bank and an active fiscal agent is known as fiscal dominance.⁶ Unlike the indeterminate cases, fiscal dominance can and does occur in advanced economies, especially in today’s political climate, where government deficits are unsustainably high.⁷

In theory, fiscal dominance could mirror monetary dominance and yield stable outcomes if fiscal authorities are credibly committed to discipline. But in practice, political incentives make this sort of commitment highly unlikely, increasing the risk of higher inflation.⁸ Several episodes from economic history demonstrate that fiscal-dominant regimes resort to the kind of policies that favor political expedience. These examples include those Western European countries that experienced hyperinflation in the interwar period and modern cases such as Argentina and Turkey.⁹ The lesson is straightforward: Without fiscal discipline, the Fed cannot achieve low and stable inflation. In today’s high-deficit environment, the US risks slipping toward fiscal dominance, where monetary policy becomes hostage to fiscal policy, thus risking higher inflation.

Understandably, most policy prescriptions that attempt to shield the Fed from fiscal dominance usually call for the fiscal agent to spend judiciously. That is a worthwhile goal, but the Fed can take steps to shield itself from fiscal dominance. In fact, the prescriptions offered in prior chapters of this series, meant primarily to improve overall monetary policy performance, can also help the US stay away from a fiscal-dominant regime. Given Congress’s penchant for increasing government expenditures, it seems wise for the central bank to act as a check on fiscal dominance.

The interaction between the monetary and fiscal authorities requires one agent to cede and relinquish control, resorting to a passive strategy to avoid the worse result, where both agents are active. The Fed must strongly signal to the fiscal authority its intent to be the active participant (proverbially tying its hands to the wheel, as one would in a game of chicken), forcing the fiscal agent to resort to its passive strategy. To credibly provide such a signal, the Fed could adopt a rules-based monetary policy framework.¹⁰

Under such a framework, the Fed would publish an arithmetic rule that sets its target for the federal funds rate based on current values of macroeconomic indicators, such as inflation, output growth, unemployment, and others. The Fed could update the rule at moderate intervals, but importantly, once the Fed publishes the rule, it must follow it. With a properly structured rule in place, an irresponsible fiscal agent cannot be bailed out by an accommodative monetary agent. This would force the fiscal agent to exercise restraint.

But self-imposed rules-based policy from the Fed cannot alone fix this problem because the central bank can always deviate from those rules. Congress must act as well. A legislative directive requiring the Fed to follow the rules it has outlined would increase the likelihood of its adherence.

In conjunction with following its rules-based policy enforced by Congress, the Fed must also shrink its balance sheet and restore monetary policy to its pre-2008 operating framework—that is, reverting from the current abundant-reserves system back to a scarce-reserves system.¹¹ This fix to the Fed’s assets column must be matched with a corresponding fix to its liabilities by ending the interest on reserves program.¹² Abundant banking reserves, created by multiple rounds of quantitative easing, have led to an economic environment in which further asset purchases largely do not affect the federal funds rate.

Under the current operating framework, the Fed can keep buying assets with little fear of creating runaway inflation because it can pay financial institutions to sit on reserves. For instance, it can buy more US Treasurys to provide funding for more government programs. Theoretically, at least, paying higher rates of interest on these reserves means that the Fed’s operations will increase aggregate bank reserves without generating more inflation from those reserves.

Consequently, Congress can use the Fed as a backdoor spending mechanism to fund its activities without going through the necessary appropriations process. This makes government borrowing and spending less sustainable and fiscal dominance more likely. A return to a scarce-reserves system would restore the link between monetary operations and market-determined interest rates, reducing the Fed’s role as a fiscal enabler.

As the US government recklessly spends without any consideration for a sustainable debt trajectory, fiscal dominance becomes increasingly likely. If fiscal dominance occurs, the central bank must set aside its mandate to stabilize inflation and instead focus on keeping the interest payments on the federal debt low. Fiscal dominance usually results in high inflation, as we have seen several times in history. To prevent fiscal dominance, the Fed should adopt a rules-based monetary policy and continue reducing its balance sheet to revert the financial system back to a scarce-reserves regime. This will improve the Fed’s performance as well as prevent the fiscal agent from subverting monetary policy.