What is fiscal dominance? Investing Explained

In this series, we break through the jargon and explain a popular investment term or theme. Here it is fiscal dominance.

Sounds a bit dubious?

The Bank of England would agree, but not for the reason you might think.

Tax dominance may sound a bit raunchy, but it is in fact a phrase that used to be limited to academic papers on mysterious economic issues. Lately, it has been popping up in news reports due to tumultuous economic and political events.

Why?

First a little background. Over the past three decades, there has been a division of labor between governments and central banks in the UK and other countries.

Governments are in charge of fiscal policy – those related to debt, deficit, expenditure and taxes.

Founded in 1694, the Bank of England is the central bank of the United Kingdom and has been independent since 1997. She is responsible for monetary policy, which means setting interest rates and controlling inflation.

Fiscal dominance is the term used to describe a situation where a central bank’s ability to fight inflation is compromised as a result of government decisions.

Experts say the disastrous mini-budget of former Chancellor Kwasi Kwarteng has caused this situation in the UK.

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In the wake of the mini-budget, the price of gilt-edged government bonds fell as international investors feared the prospect of unfunded tax cuts.

As a result, the yields on gold rose and with it the costs of government loans.

The Bank of England was about to begin phasing out the money-printing quantitative easing program that had bought it billions of pounds of government bonds to keep borrowing costs down after the global financial crisis and during the pandemic. But as the mini-fiscal crisis worsened, the bank was forced to step in for a period of days and pledged to buy £65bn worth of government bonds to slow the rise in yields. Total purchases of gilts by the Bank amounted to £19.5 billion.

Why was that fiscal dominance?

Economists argued that the Bank’s apparent willingness to print money to save the government — a move most likely to be inflationary — represented fiscal dominance. This was because the government was in charge and nullified the division of labor.

Much of the concern over this issue stems from periods in the past when central banks financed government debt and thereby fueled hyperinflation. This was the case during the Weimar Republic in Germany in the 1920s and Latin America in the 1980s.

How was the rescue operation viewed?

Opinions differ and some argue that the Bank did not act quickly enough and mismanaged communications.

For some, bank governor Andrew Bailey was the hero of the hour. But Bailey, once dubbed the “sexy turtle,” has also been criticized for the Bank’s slowness to tackle inflation in a timely manner.

The gilt sell-off, quantitative tightening, will resume on November 1.

What does Rishi think?

It appears that his government will avoid new charges of fiscal dominance.

Speaking at the Tory’s leadership contest in the summer, he said his predecessor Liz Truss’ plan to curtail the bank’s independence would “be bad for all of us” — and could lose investor confidence in the economy.