Strong fiscal rules, independent oversight, and coordinated policymaking can safeguard monetary policy credibility and economic stability in Asia and the Pacific.
From the Asian financial crisis to the global financial crisis, governments and central banks are working together to shore up economic growth and employment, while keeping inflation and government debt in check.
Fiscal stimulus during crises years came in the form of spending and subsidies, which ballooned debt; monetary stimulus arrived through low interest rates and liquidity injections, which flooded economies with cheap credit. Unprecedented government support during the COVID-19 pandemic led to a surge in public debt like never before.
With ongoing global turbulence continuing to necessitate government support and repeated economic shocks straining revenues, central banks now face a unique bind, while at the same time navigating elevated debt levels resulting from earlier emergency spending.
At the very core, this means pressure to keep interest rates low to ease borrowing costs and support economic growth even if that means looking the other way on inflation. This is fiscal dominance in action: when monetary policy deviates from its main price stability goal and starts cushioning the budget.
This leads to compromised decisions and blurred mandates since central banks that should be taming inflation are instead cornered into propping up fiscal solvency. Fiscal dominance can lead to disastrous outcomes: inflationary spirals that erode spending power, weaken monetary policy credibility, and ultimately undermine both macroeconomic stability and long-term growth.
Effective coordination between monetary and fiscal policy is crucial to balance economic growth, control inflation, and ensure fiscal sustainability, helping governments respond to crises without undermining central bank independence or financial stability.
So, when do central banks actually bow to fiscal pressure? Our research for the report, Monetary Policy Under Fiscal Stress: A Forward-Looking Analysis of Fiscal Dominance, published in the Journal of Macroeconomics, found that they adjust policy rates in response to expected fiscal deficits, especially in emerging economies with weak institutional guardrails, including less independent central banks and limited fiscal control.
Where central bank independence is low, debt levels are high, and no formal debt rules exist, monetary policy is prone to be more reactive to fiscal pressure. The pattern has sharpened post-pandemic. Since 2022, our study finds that the response of interest rates to fiscal stress has grown stronger, meaning fiscal dominance is fast becoming a core challenge for policymakers.
We found that fiscal rules do limit fiscal dominance since they work to keep the government’s balance sheet in check. Done right, they act as a firewall between fiscal politics and monetary decisions, which is crucial for keeping central banks focused on inflation, not budget bailouts.
However, not all fiscal rules are built the same. Debt-focused rules such as debt ceilings or debt-to-GDP targets are more effective at curbing fiscal dominance than rigid budget balance rules, which often force damaging short-term-focused fiscal consolidations and push central banks off course.
Debt rules offer flexibility while preserving long-term sustainability, easing the pressure on monetary policy. But rules need bite: enforcement, transparency, and independent oversight.
Our study also shows that even with inflation-targeting frameworks, countries without real central bank autonomy often cave to fiscal pressure, especially during crisis periods. This risk is greatest in emerging markets, where weak institutions leave central banks vulnerable to political interference.
Safeguarding independence demands strong mandates, transparent processes, and public trust, all of which translates to credibility and effective policymaking. Clear communication helps central banks hold the line and keep inflation in check when fiscal pressures mount.
Our research also identifies an important flip side: in economies with high levels of foreign-currency debt, fiscal dominance pushes interest rates up as central banks try to prop up the exchange rate and manage valuation risks.
Unlike those pressured to lower interest rates to ease domestic debt burdens, these economies may be forced to raise rates, not to fight inflation, but to defend their currency and limit the rising cost of repaying foreign-denominated debt.
This creates a painful trade-off: tightening monetary policy even as growth falters. This is fiscal dominance of a unique kind, one driven by exchange rate dynamics rather than driven by domestic deficits. Managing this tension demands more than just central bank independence; it calls for deep institutional resilience, credible fiscal anchors, and nimble, coordinated policymaking that can stabilize markets without derailing recovery.
As debt piles up and the global economy slows, the tug-of-war between fiscal needs and monetary credibility is intensifying. Our study provides firm evidence to back what many central bankers around the world already face: when the budget breathes down your neck, staying focused on inflation gets harder.
The way forward? Smarter fiscal rules, stronger institutions, and unwavering central bank independence. Because once fiscal dominance sets in, getting monetary policy back on track is not just difficult, it is costly. And once monetary policy credibility is lost, regaining macroeconomic stability becomes far more challenging.
This blog post is based on the paper, Monetary policy under fiscal stress: A forward-looking analysis of fiscal dominance.