Fiscal Dominance: The End of Inflation Targeting?

The acceleration of government expenditures and public debt in both developed and developing countries has prompted concerns about the medium-term sustainability of fiscal policies. If these trends persist, countries may reach a point in the coming decades when fiscal dominance is challenged and the central bank’s ability to combat inflation through higher interest rates is constrained by the risk of undermining fiscal sustainability. Experts have frequently pointed out that, under such conditions, the central bank may be forced to abandon inflation targeting and adopt a more passive role. This paper offers an alternative scenario by proposing that the central bank’s mandate be adjusted to reflect the evolving economic landscape, specifically by incorporating the level of real public debt. This adjustment to the central bank’s mandate means that the optimal monetary policy rule would directly depend on the fiscal policy regime. The analysis conducted here using a New Keynesian DSGE model demonstrates that the kind of change in the mandate that this article proposes would make central bank policy more resilient toward changes in the fiscal policy regime and facilitate balance between stabilized inflation, output, and the level of public debt. In addition, the inclusion of debt in the central bank mandate would enable the bank to retain its active role in fighting inflation in response to an active fiscal policy. The article indicates that a fiscal dominance regime does not necessarily force the central bank to completely lose its independence in shaping monetary policy or to abandon the basic principles of inflation targeting.