Image source: Wikipedia

“Fiscal dominance” refers to a situation where government debt grows so large that the nation’s central bank feels that it has little choice except to focus on making sure the government does not default–even if it means a surge of inflation. Janet Yellen described the issue and risks of fiscal dominance concisely in her comments at a session on the future of the Federal Reserve at the recent meetings of the Allied Social Science Associations in Philadelphia (January 6, 2026).

This postwar policy framework is characterized by monetary policy dominance that is, the Fed is not and must never become the fiscal authority’s financing arm. Fiscal policy’s job is to set taxes and spending, and to finance deficits through issuing debt to the market at prevailing interest rates. It is the responsibility of Congress and the president—not the Federal Reserve—to insure that the government’s intertemporal budget constraint is satisfied. It is their duty to ensure that the path of debt is sustainable. 

Fiscal dominance refers to the opposite configuration—a situation where the government’s fiscal position—its deficits and debt—puts such pressure on its financing needs that monetary policy becomes subordinate to those needs.As a result, the central bank is pressured, implicitly or explicitly, to keep interest rates lower than warranted by macroeconomic conditions; or to purchase large quantities of government debt, not primarily to stabilize inflation and employment but to ease the government’s financing burden. In a fiscally dominant world, the government’s intertemporal budget constraint drives the price level. If markets don’t expect future primary surpluses to cover the debt, the adjustment eventually comes via inflation or default. This is the “fiscal theory of the price level.”

Fiscal dominance is dangerous because it typically results in higher and more volatile inflation or politically driven business cycles. When the central bank is constrained from raising rates or shrinking its balance sheet because that would increase debt service or trigger fiscal stress, inflation expectations may become unanchored. Households and firms may come to expect that inflation is the path of least resistance for managing high debts. Once such expectations take hold, stabilizing prices becomes significantly more costly. If inflation is firmly under control, the Fed has more flexibility to respond to labor market weakness. Fiscal dominance is also likely to raise term premia and borrowing costs as investors become concerned that the government will rely on inflation or financial repression to manage its debt. In addition, a central bank that is perceived as an arm of the Treasury may have less space to act forcefully in a crisis. For all of these reasons, avoiding fiscal dominance has been a central objective of modern central banking frameworks. 

Yellen does not believe that the US Federal Reserve currently faces a situation of “fiscal dominance”. But with the federal government running high annual deficits, while having already accumulated historically high levels of total debt, political pressures are building in that direction. Yellen says:

What would keep the U.S. out of fiscal dominance? First and foremost, this requires credible medium-term fiscal adjustment—not abrupt austerity, but a believable path that stabilizes debt/GDP; for example, through gradual changes to taxes and entitlements or reforms that tilt growth and productivity higher. Unfortunately, however, the revealed preference of both parties has been toward deficit-increasing policy. … I doubt that Americans will end up on the fiscal dominance course, but I definitely think the dangers are real.  

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