Since last year, all major economies have experimented with an unprecedented scale of monetary-fiscal policy coordination to cope with the COVID-19 pandemic. Such a prompt, bold approach prevented the worst-case scenario of massive, prolonged layoffs and corporate bankruptcies around the world.

The closer policy coordination reflects the views embraced by academics and economists in the countries that struggled with limited inflationary pressure before the pandemic. Namely, that fiscal stimulus is desirable when the effectiveness of unconventional monetary easing tools diminishes over time; that the crowding-out effect on private investment would be limited under zero lower bound on interest rates; and that higher levels of public debt could be sustained as long as central banks can maintain large-scale purchases of government bonds.

Emboldened by such views, advanced economies including the Eurozone, Japan and the United States expanded fiscal deficits and public debt since the pandemic.

On average, the public expenditure-to-GDP ratio rose by about 10 percentage points among Group of Seven economies, and their central banks purchased more than a half of newly issued bonds from markets. In contrast, the ratio for emerging economies rose on average by a mere 3 percentage points. This is because emerging economies depend heavily on foreign investors, who tend to be less tolerant of poor fiscal performance. And due to smaller domestic currency-denominated public debt, therefore, there are limitations for those central banks in conducting quantitative easing operations.

The combination of growing public debt and massive quantitative easing, as seen in many advanced economies like the United States and Japan, is often criticized as “monetization of fiscal deficit,” where central banks print money to finance government spending. This could be a slippery slope, which possibly leads to the situation where governments are stuck in excess reliance of QE, or in some cases lead to high inflation.

To deflect such criticism, central banks claim that their monetary policy framework maintains “monetary dominance.” The idea is that central banks conduct monetary policy to keep medium and long-term price stability — such as achieving 2% inflation — by maintaining operational independence from the government, which is responsible for fiscal policy, such as overseeing spending and taxes. Massive buying of government bonds, which are financed by expanding reserve money at central banks, is one of the major unconventional monetary-easing tools to achieve 2% inflation.

The polar opposite of monetary dominance is “fiscal dominance,” where fiscal policy takes precedence over monetary policy. In this case, governments run up fiscal deficits and public debt, forcing central banks to buy government bonds to allow for expansionary spending, at the expense of price stability.

It’s a label that central banks vehemently deny. Central bankers certainly don’t want to be seen as compromising on their independence and policy autonomy. And yet, the closer coordination of fiscal and monetary policy is increasingly giving the optics of fiscal dominance.

Inflation dynamics have drastically changed this year. Inflation has climbed and remained stubborn, due to a range of commodity price hikes, semiconductor shortages, global economic recovery pace and unstable supply-chain networks.

Out of fear that the current high inflation will spill over to inflation expectation, central banks in emerging economies raised policy rates, and advanced economies have ended or tapered their quantitative easing operations, preparing for a series of policy rate hikes.

As central banks continue to raise policy rates — such as the federal funds rate — shorter-term government bond yields are likely to face upward pressures over time. If the trend continues, shorter-term yields will continue to rise while long-term debt yields remain relatively flat — therefore leading to an inverted yield curve. So as policy rates continue to rise, at some point, central banks engaged in quantitative easing must also cut their balance sheets from unprecedentedly high levels in order to raise long-term debt yields to avoid an inverted yield curve.

In the previous normalization period between 2014-2019, the Fed was able to take a gradual approach in the muted inflationary environment.

This time, however, inflationary dynamics differ significantly, with greater uncertainty. As yield curves are already so flattened, central banks may need to rely more on reducing their holdings of government bonds to prevent an inversion of the yield curve. In that case, long-term government bond yields could rise faster than currently expected.

Given that the average public debt-GDP ratio exceeds 120% in advanced economies, increased interest payments may cause significant stress on fiscal performance. This may put monetary policy normalization process in a challenging situation.

The delayed process could undermine central banks’ credibility and intensify criticism that central banks’ operations are inching closer to fiscal dominance. Whether central banks can maintain their claim on monetary dominance could be tested sooner than expected.

Sayuri Shirai is a professor at Keio University and a former Policy Board member of the Bank of Japan.

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