“There are only three ways to meet the unpaid bills of a nation. The first is taxation. The second is repudiation. The third is inflation.”  US President Herbert Hoover 

Understanding Fiscal Dominance 

The term “fiscal dominance” has recently entered the day-to-day financial market conversation, but what does it mean and why does it matter? 

To understand it fully we must turn the clock back to the glory days of central bank independence, when New Zealand set an example for the rest of the world. In February 1990, we became the first country to officially set an inflation target for our central bank and throughout the 1990s other countries followed with measures to deliver central bank independence.  

This was in stark contrast to the murkier arrangements that existed prior. It is hard to believe that there was a time when interest rate changes by the Reserve Bank of Australia were announced by the Treasurer, a political figure. 

The 1990s ushered in an era of “monetary dominance” where the goals, operations and communications of central banks were focused on controlling inflation. Governments could pursue other goals with their fiscal policy but if they ran the risk of fuelling excessive demand in the economy, they could expect offsetting measures from the central bank as it focused purely on inflation.  

From Crisis Response to Long-Term Risk 

The aims of governments and central banks were not always in opposition. Coordinated efforts were needed to address the challenges of the Global Financial Crisis and the COVID Pandemic. An “all hands to the pump” approach was deployed in what were considered exceptional times. Interest rates were cut and stimulus plans launched to rescue economies. 

However, the legacy of the COVID pandemic has been a step wise change upwards in government debt levels and ongoing annual deficits. This year the US federal government is running its third largest deficit, surpassed only by 2020 and 2021. 

The concern is that central bank policies might begin to suffer from what is called “fiscal dominance”. This is where the most immediate concern is enabling the government to fund itself and inflation fighting takes a backseat. 

Political Pressure and Historical Lessons 

In July, President Trump wrote a note to Fed Chair Powell saying; “You have cost the USA a fortune and continue to do so,” and “You should lower that rate by a lot. Hundreds of billions of dollars are being lost.”  

This is a clear example of politicians attempting to place the funding of the federal debt ahead of other economic priorities despite the longer-term risks. 

Other historical examples include during World War II when the Federal Reserve set interest rates low to enable a war time deficit in the order of 30% of GDP to be funded. Inflation subsequently rose to 20% in 1947. 

Latin American countries embraced fiscal dominance during the 1970s and suffered hyperinflation and currency devaluations as a result. 

Some economists regard the Bank of Japan’s actions in recent decades as reflecting fiscal dominance. Interest rates at near zero enabled public debt ratios to skyrocket without burdening the government with a massive interest bill. So far, the inflation consequences have been relatively benign, but the country now has consumer inflation higher than the US or Europe. 

A recent brief example is what is being labelled as the “Liz Truss” moment in 2022. A profligate mini-budget resulted in a crisis in the UK gilt market and the Bank of England was forced to pause its inflation fighting offensive and intervene in the market to rescue the government from its mistake. 

The Hangover Effect 

In its March Forecast the Congressional Budget Office projected that the US federal debt could reach 150% of GDP in the next twenty years and warned that the position would be “…vulnerable to an increase in interest rates…” 

In New Zealand, the recently released Long Term Fiscal Statement from Treasury has net core Crown debt reaching a similar ratio in the mid 2050s if fiscal policy does not change from current settings. 

The International Monetary Fund once referred to the long-term effects of the COVID pandemic as an “economic hangover”.  

Faced with what seems like an inexorable upward march in government debt levels, there is a risk that funding imperatives overshadow inflation fighting goals for policy makers. Fiscal dominance sounds like a dull, arcane economic term but when it aggravates an existing cost of living crisis it will be all too real for ordinary folks. This wouldn’t be an unforeseeable “black swan” development, as it is a known risk. It could better be described as a “grey rhino”, a term used to describe a visible, slow-moving danger.  

Let’s hope it doesn’t turn on us.  

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An amended version of this article was originally published in the NBR on 30 September 2025 (paywalled).