What is fiscal dominance? Investing Explained

In this series, we bust the jargon and explain a popular investing term or theme. Here it’s fiscal dominance. 

Sounds a bit dubious? 

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

Fiscal dominance may sound faintly raunchy but it is, in fact, a phrase that used to be confined to academic papers on arcane economic issues. Lately it has been popping up in news stories due to tumultuous economic and political events. 

Why? 

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

Governments have charge of fiscal policies – those relating to debt, deficits, spending and taxation. 

The Bank of England, set up in 1694, is the UK’s central bank and has been independent since 1997. it is responsible for monetary policy, which involves setting interest rates and controlling inflation. 

Fiscal dominance is the term used to describe a situation when a central bank’s ability to combat inflation is compromised because of decisions made by government. 

In the view of experts, former Chancellor Kwasi Kwarteng’s catastrophic mini-Budget caused this situation in the UK. 

Tell me more 

In the wake of the mini-Budget, the price of government gilt-edged bonds slumped as international investors took fright over the prospect of unfunded tax cuts. 

This caused gilt yields to soar and, with them, the cost of government borrowing. 

The Bank of England had been about to start unwinding the quantitative easing ‘money-printing’ programme, under which it had bought up billions of pounds of gilts to keep borrowing costs low after the global financial crisis and during the pandemic. But as the mini-Budget crisis worsened, the Bank was forced to intervene for a period of days, pledging to buy £65billion worth of gilts to slow the surge in yields. The Bank’s total purchases of gilts were £19.5billion. 

Why was that fiscal dominance? 

Economists argued that the Bank’s apparent willingness to print money to bail out the Government – a course of action highly likely to be inflationary – represented fiscal dominance. This was because the Government was calling the shots, overriding the division of duties. 

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

How was the bailout viewed?

Opinions differ, with some claiming that the Bank failed to act quickly enough and managed communications poorly. 

For some, Bank governor Andrew Bailey was the hero of the hour. But Bailey, once dubbed the ‘sexy tortoise’, has also been widely criticised for the Bank’s slowness in tackling inflation in a timely fashion. 

The sell-off of gilts, quantitative tightening, is set to resume on November 1. 

What does Rishi think?

It seems his government will be avoiding fresh accusations of fiscal dominance. 

During the summer Tory leadership contest, he said his predecessor Liz Truss’s plan to limit the Bank’s independence would be ‘bad for all of us’ – and that investors could lose faith in the economy.