Financial markets face a growing threat of ‘fiscal dominance’ – when finance ministries force central banks to underwrite government debt or reduce interest rates to cope with burgeoning government debt. As has long been recognised, hampering central banks’ independence weakens safeguards against inflation, upsets markets and ends up not supporting but reducing growth.
Fragile economies such as Argentina and Türkiye illustrate the hazards of allowing monetary policy to become hostage to fiscal imperatives. Today, the risk extends to the US, Europe and Japan. With mounting public debt, the danger is that price stability no longer remains the primary objective – it becomes subordinate to budgetary sustainability.
If a central bank cannot raise rates because the Treasury won’t allow it, then it ceases to be a central bank. It becomes a government agency.
Jerome Powell, the Federal Reserve chair, looks likely to stand firm against President Donald Trump’s attempts to remove him from office before his term ends in May. He has hinted at a possible rate cut at the Fed’s next policy-setting meeting on 17 September, as a result of weaker labour market data.
But – reflecting news of 2.9% annual US inflation in August – he and the rest of the Federal Open Market Committee seem highly unlikely to relax policy sufficiently to appease Trump. The president’s campaign to remove Fed Governor Lisa Cook on contested allegations of mortgage fraud seems likely, if anything, to strengthen the FOMC’s resolve to resist political pressure.
Turbulence in Europe
In Europe the independence of the European Central Bank is enshrined in constitutional law. But governments’ apparent incapacity to curb rising debt may increase the likelihood of attempts – direct or indirect – to constrain its freedom of action.
The collapse on 8 September of François Bayrou’s government is a further sign of endemic French inability to curb progressively higher government spending. President Emmanuel Macron’s nomination of Sébastien Lecornu as the fifth prime minister of his second term is unlikely to change the general negative view of France on international bond markets.
European governments have little or no direct means to force the ECB into maintaining low interest rates. However, the lack of direct leverage over central banks’ day-to-day operations may increase governments’ desire to influence the ECB’s stance through nominations to the executive board and to the national central banks that make up the ECB’s governing council.
Four prominent members of the ECB board, including President Christine Lagarde, are due to leave between summer 2026 and January 2028. This gives European Union governments an unusual opportunity to reshape the ECB’s key personnel.
Significantly, both Lagarde and François Villeroy de Galhau, governor of the Banque de France, are scheduled to step down in November 2027. This is after Macron departs following the French presidential election in April 2027. If one or both central bankers left their jobs early, this would allow Macron to guide succession. It would prevent key positions being influenced by his own successor who may be less welded to the principles of European integration.
Unease about inflation
Personnel decisions in both the US and the EU will be affected by continued debate about whether leading global central banks helped spur the 2021-22 inflation upsurge through quantitative easing – and whether, in the aftermath, they acted quickly enough to reduce it.
In the US, Trump’s ‘big, beautiful’ tax bill raised the debt ceiling by $5tn, extending President Joe Biden’s massive fiscal expansion. This has added to investor unease about the future credibility of US Treasury issuance.
Could tariffs help? Last month, the Congressional Budget Office projected that Trump’s tariffs would generate $4tn in additional revenue over the next decade. This could offset the tax cuts in his mega-bill – but the arithmetic is open to question and the outcome uncertain.
Using fiscal and monetary levers to assist the economy works well only if such action is backed by investor confidence. Monetary policy can create fiscal space by holding financing costs down. Fiscal policy, used wisely, can reinforce monetary credibility. Yet central banks must place greater emphasis on reducing inflationary risks. Monetary accommodation without fiscal restraint can again become dangerous – especially since inflation has not yet returned to target.
In the euro area, the ECB’s ‘transmission protection instrument’, introduced in July 2022, is designed to reassure investors that fragmentation will not be tolerated. For high-debt countries like Italy and France, it is a shield. But, for the ECB, it risks blurring the line between market stabilisation and state financing.
In Washington, the same risk looms. Once investors conclude that politics has captured monetary policy, confidence could unravel abruptly. Preserving a credible, independent central bank is not a luxury. It is the essential safeguard against tolerating a permanent uptick in inflation and destabilising global markets.
Edoardo Reviglio is Professor of Economics at LUISS Guido Carli and Member of the OMFIF Advisory Council.
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