Fiscal Dominance and the Long-Term Interest Rate

Very high government debt/GDP ratios will increase uncertainty about inflation and the future path of real interest rates. This will reduce substitutability across the yield curve. In such circumstances, changes in the short-term/long-term mix of government debt held by the public will become more effective in achieving macroeconomic objectives. In circumstances of imperfect substitutability, central bank purchases or sales of government bonds have been seen historically as a key tool of monetary policy. Since the mid-1990s, however, responsibility for government debt management has been assigned to other bodies. The mandates of the government debt manager could have the unintended consequence of making their actions endogenous to macroeconomic policies. There is evidence that decisions on the maturity of debt have in the past been linked to both fiscal and monetary policy. Recent Quantitative Easing (QE) by the central bank must be analysed from the perspective of the consolidated balance sheet of government and central bank.