# Reforming the Federal Reserve, Section 5: Preventing Fiscal Dominance To prevent fiscal dominance, the Fed should adopt a rules-based monetary policy and continue reducing its balance sheet. September 25, 2025 • Publications By [Norbert J. Michel](https://www.cato.org/people/norbert-michel) and [Jai Kedia](https://www.cato.org/people/jai-kedia) ![Reforming the Fed Reserve (no text)](/sites/cato.org/files/styles/aside_3x/public/2025-04/Reforming%20Fed%20Reserve_0.jpg?itok=FP84B9tQ) #### [Reforming the Federal Reserve](https://www.cato.org/reforming-federal-reserve) 9-part series - ##### [Reforming the Federal Reserve, Section 1: A Brief Look Back and the Way Forward](/publications/reforming-federal-reserve-part-1-brief-look-back-way-forward) By [Norbert J. Michel](https://www.cato.org/people/norbert-michel) and [Jai Kedia](https://www.cato.org/people/jai-kedia) - ##### [Reforming the Federal Reserve, Section 2: Enforcing Rules-Based Monetary Policy](/publications/reforming-federal-reserve-part-2-enforcing-rules-based-monetary-policy) By [Norbert J. Michel](https://www.cato.org/people/norbert-michel) and [Jai Kedia](https://www.cato.org/people/jai-kedia) - ##### [Reforming the Federal Reserve, Section 3: Restoring Sensible Asset Purchases](/publications/reforming-federal-reserve-part-4) By [Norbert J. Michel](https://www.cato.org/people/norbert-michel) and [Jai Kedia](https://www.cato.org/people/jai-kedia) - ##### [Reforming the Federal Reserve, Section 4: Ending the Interest on Reserves Program](/publications/reforming-federal-reserve-part-5) By [Norbert J. Michel](https://www.cato.org/people/norbert-michel) and [Jai Kedia](https://www.cato.org/people/jai-kedia) - ##### [Reforming the Federal Reserve, Section 5: Preventing Fiscal Dominance](/publications/reforming-federal-reserve-part-8-preventing-fiscal-dominance) By [Norbert J. Michel](https://www.cato.org/people/norbert-michel) and [Jai Kedia](https://www.cato.org/people/jai-kedia) - ##### [Reforming the Federal Reserve, Section 6: Responsible Last Resort Lending](/publications/reforming-federal-reserve-part-6) By [Norbert J. Michel](https://www.cato.org/people/norbert-michel) and [Jai Kedia](https://www.cato.org/people/jai-kedia) - ##### [Reforming the Federal Reserve, Section 7: A Glance at Interventions in Payment Services](/publications/reforming-federal-reserve-part-3-a-glance-at-interventions-in-payment-services) By [Nicholas Anthony](https://www.cato.org/people/nicholas-anthony) - ##### [Reforming the Federal Reserve, Section 8: Shrinking Regulatory Authority](/publications/reforming-federal-reserve-part-7) By [Norbert J. Michel](https://www.cato.org/people/norbert-michel) and [Jai Kedia](https://www.cato.org/people/jai-kedia) - ##### [Reforming the Federal Reserve, Section 9: Dispelling Myths About the Fed](/publications/reforming-federal-reserve-part-9-dispelling-myths-about-fed) By [Norbert J. Michel](https://www.cato.org/people/norbert-michel) and [Jai Kedia](https://www.cato.org/people/jai-kedia) [ Return to Series Home ](https://www.cato.org/reforming-federal-reserve) [ Download PDF ](https://www.cato.org/sites/cato.org/files/2026-01/Reforming-the-Federal-Reserve.pdf) Almost all early central banks were created to help finance government expenditures—that is, they were designed to facilitate government borrowing, often through direct purchases of government debt.[1](#_edn1) Over time, developed countries have moved away from such arrangements, and central banks have taken on broader macroeconomic responsibilities while maintaining a degree of independence from the government’s borrowing and spending. 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](#_edn2) 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](#_edn3) 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. ## Fiscal Dominance Explained 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](#_edn4) 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](#_edn5) 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](#_edn6) 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](#_edn7) 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](#_edn8) 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](#_edn9) 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. ## Asserting Monetary Dominance 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](#_edn10) 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](#_edn11) 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](#_edn12) 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. ## Conclusion 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. [![Reforming the Federal Reserve Full Cover](/sites/cato.org/files/styles/serial_cover_phone/public/2026-01/reforming-the-fed-full-book-cover.png?itok=z1Ghoblw)](https://www.cato.org/sites/cato.org/files/2026-01/Reforming-the-Federal-Reserve.pdf) ### Download This Publication ##### Reforming the Federal Reserve, Section 5: Preventing Fiscal Dominance [ Download PDF ](https://www.cato.org/sites/cato.org/files/2026-01/Reforming-the-Federal-Reserve.pdf) ##### About the Authors [![Norbert Michel Cropped](/sites/cato.org/files/styles/author_picture/public/2025-01/norbert-m-cropped.jpg?itok=8WIx97Dk)](/people/norbert-michel) ##### [Norbert J. Michel](/people/norbert-michel) Vice President and Director, Center for Monetary and Financial Alternatives, Cato Institute [ ](https://x.com/norbertjmichel) [![jai-kedia-cropped.jpg](/sites/cato.org/files/styles/author_picture/public/2023-07/jai-kedia-cropped.jpg?itok=In6dB8gW)](/people/jai-kedia) ##### [Jai Kedia](/people/jai-kedia) Research Fellow, Center for Monetary and Financial Alternatives, Cato Institute [ ](https://x.com/jaikedia) Show Endnotes Hide Endnotes ##### Notes [1](#_ednref1). Michael D. Bordo, “[A Brief History of Central Banks](https://www.clevelandfed.org/publications/economic-commentary/2007/ec-20071201-a-brief-history-of-central-banks),” Federal Reserve Bank of Cleveland, December 2007; and Kurt Schuler, “The World History of Free Banking: An Overview,” in *The Experience of Free Banking*, 2nd ed., ed. Kevin Dowd (Institute of Economic Affairs, 2023), pp. 36–42. [2](#_ednref2). At the very least, expansionary monetary policy can lead to inflation, which can affect the real cost of government debt. Christopher A. Sims, “[Luncheon Address: Fiscal Policy, Monetary Policy and Central Bank Independence](https://www.kansascityfed.org/Jackson%20Hole/documents/7040/SimsPaper_JH2016.pdf),” speech, Jackson Hole Economic Policy Symposium, Federal Reserve Bank of Kansas City, August 26, 2016, Jackson Hole, WY. [3](#_ednref3). Donna Faye E. Bajaro et al., “[Monetary Policy Under Fiscal Stress: A Forward-Looking Analysis of Fiscal Dominance](https://www.sciencedirect.com/science/article/abs/pii/S0164070425000370),” *Journal of Macroeconomics* 86 (December 2025), published ahead of print. [4](#_ednref4). Of course, these are the possibilities in the present state of the world, where a central bank is tasked with achieving specific desirable macroeconomic outcomes. Within such a world, the ideal outcome is a monetary-dominant regime. This should not be construed to mean that this outcome is the first-best one altogether—the truly best outcome would likely be achieved through privately supplied money with no central bank involvement at all. [5](#_ednref5). In the case of indeterminacy, there are multiple possibilities for inflation, including both stable and unstable outcomes. Market participants’ beliefs about the economy ultimately dictate which state the economy settles into. In countries like the US, strong inflation anchors and institutional trust generally lead to stable outcomes even under indeterminacy. But with enough erosion of trust, active/​active and passive/​passive cases in the US could lead to a volatile economy as it has in other countries, such as Argentina or Turkey. [6](#_ednref6). Eric M. Leeper, “[Equilibria Under ‘Active’ and ‘Passive’ Monetary and Fiscal Policies](https://www.sciencedirect.com/science/article/abs/pii/030439329190007B),” *Journal of Monetary Economics* 27, no. 1 (February 1991): 129–47; and Neil Wallace and Thomas J. Sargent, “[Some Unpleasant Monetarist Arithmetic](https://www.minneapolisfed.org/research/quarterly-review/some-unpleasant-monetarist-arithmetic),” Federal Reserve Bank of Minneapolis *Quarterly Review* 5, no. 3 (Fall 1981): 1–17. [7](#_ednref7). For examples, see Eric M. Leeper, “[Fiscal Dominance: How Worried Should We Be?](https://www.mercatus.org/research/policy-briefs/fiscal-dominance-how-worried-should-we-be),” Mercatus Center at George Mason University, March 2023. [8](#_ednref8). Romina Boccia and Dominik Lett, “[The Threat of Fiscal Dominance: Will the US Resort to Money-Printing to Finance the Rising Debt Challenge?](https://www.cato.org/blog/threat-fiscal-dominance-will-us-resort-money-printing-finance-rising-debt-challenge),” *Cato at Liberty* (blog), Cato Institute, April 4, 2024. [9](#_ednref9). In a famous essay, Thomas Sargent shows that the hyperinflation in Western European countries only ended after the establishment of independent central banks that were legally required to refuse their governments’ requests for unsecured debt. Since the fiscal agents could only secure quality financing by showing strict adherence to a sustainable path for their deficits, their economies switched from fiscal-dominant to monetary-dominant regimes, and price levels stabilized. Thomas J. Sargent, “[The Ends of Four Big Inflations](https://www.nber.org/books-and-chapters/inflation-causes-and-effects/ends-four-big-inflations),” in *Inflation: Causes and Effects*, ed. Robert E. Hall (University of Chicago Press, January 1982), pp. 41–98. [10](#_ednref10). See section 2 of this publication for more on rules-based monetary policy: Norbert Michel and Jai Kedia, “[Enforcing Rules-Based Monetary Policy](https://www.cato.org/publications/reforming-federal-reserve-part-2-enforcing-rules-based-monetary-policy),” Reforming the Federal Reserve, Cato Institute. [11](#_ednref11). See section 3 of this publication for more on the Fed’s asset purchases: Norbert Michel and Jai Kedia, “[Restoring Sensible Asset Purchases](https://www.cato.org/publications/reforming-federal-reserve-part-4),” Reforming the Federal Reserve, Cato Institute. [12](#_ednref12). See section 4 of this publication for more on interest on reserves: Norbert Michel and Jai Kedia, “[Ending the Interest on Reserves Program](https://www.cato.org/publications/reforming-federal-reserve-part-5),” Reforming the Federal Reserve, Cato Institute. 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