Aug 25 (Reuters) – Rising borrowing costs for heavily indebted governments and growing strains in sovereign bond markets are forcing investors to confront a question once considered unthinkable: will central banks ultimately be called on to help pay the bill?
This topic of “fiscal dominance” will be one of the key questions facing the Federal Reserve’s new chair, Kevin Warsh, and some of the world’s leading economists and central bankers at the Fed’s annual gathering in Jackson Hole, Wyoming, this week.
Fiscal dominance is a situation where a government leans on its central bank to buy its bonds, or support it in other ways, because it can no longer manage on its own. For decades, this has been treated as taboo in wealthy countries.
The concern is that if a central bank prints money to plug budget deficits, that risks stoking inflation, devaluing the currency and sending foreign creditors running for the exit.
By contrast, an institution free from political pressure can focus on controlling inflation, so helping preserve confidence in a country’s money and its bonds.
But ballooning debt burdens are prompting debate about where the line between fiscal and monetary policy should be drawn.
WHAT HAPPENS WHEN GOVERNMENTS COME UNDER MARKET PRESSURE?
In theory, if a government’s borrowing costs shoot up in financial markets, that should be a signal to tighten its belt: spend less, raise taxes or both.
In practice, those choices are politically painful.
So governments have long turned to shortcuts instead: stopping money from leaving the country, compelling some domestic investors to chip in, or – in a move that is easy to enact because it is invisible at first – getting the central bank to print money and hand it over.
This so-called monetary financing, which produced runaway inflation in Argentina and, historically, in Weimar Germany, has officially been banned in advanced economies in recent decades.
WHY IS THIS BEING DISCUSSED NOW?
Public debt has climbed steadily since the 2008 financial crisis and shot up further during the COVID-19 pandemic.
The United States has run deficits exceeding 4% of economic output every year since 2019, a level normally associated with recessions, despite sustained growth.
Investors have largely absorbed the extra issuance, but demand is showing signs of strain. Long-dated Treasury yields have risen sharply, pushing up costs at bond auctions.
The Treasury has tried to ease pressure through increased buybacks of older bonds. But the impact has been limited because, unlike the Fed, the Treasury has only finite resources and cannot create money to purchase debt.
In a possible sign of interference, Treasury Secretary Scott Bessent even suggested that the Fed “consider upsizing” its own lending facility for foreign central banks to shield the U.S. bond market from volatility abroad.
COULD CENTRAL BANKS BE PRESSURED TO STEP IN?
Major central banks, including the Federal Reserve, the European Central Bank and the Bank of Japan, are formally independent, a system known as monetary dominance.
Fed chair Warsh, who had left the institution in 2010 in protest at a bond-buying programme, has rejected speculation he will be more open to doing the bidding of President Donald Trump than his predecessor Jerome Powell was.
Yet history shows the boundary between autonomy and intervention is often blurred.
In 2011, the Fed launched “Operation Twist”, selling short-term Treasury securities and buying longer-dated ones in an effort to reduce borrowing costs across the economy.
The programme was justified as part of the Fed’s employment and inflation mandate, but it also lowered Washington’s financing costs.
Japan’s central bank capped long-term bond yields for nearly a decade, making it easier for one of the world’s most indebted governments to finance itself. Its tolerance of high inflation in recent years has also been seen as the result of government pressure.
The ECB has likewise faced criticism over its bond-buying programmes.
WHAT HAPPENS NEXT?
For now, this remains speculation.
Some proposals are radical. Ideas ranging from cancelling U.S. government debt to writing off bonds held by France’s central bank have resurfaced, but mainstream economists argue such moves would damage confidence and, in Europe, could breach EU rules.
History suggests these arguments become louder in periods of economic stress.
During World War Two, for instance, the Fed effectively capped yields on government bonds to help finance the war effort.
That arrangement ended with the 1951 Treasury-Federal Reserve Accord, widely regarded as a defining moment that restored the central bank’s independence.
As today’s debt piles grow ever larger, investors are increasingly asking whether that separation can hold.
(Reporting by Francesco Canepa; Editing by Mark John and Chizu Nomiyama )
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