Every time I see references in academic papers to “fiscal dominance,” I envision a gigantic dominatrix, whip in hand, staring down at the world.
And that isn’t far from the truth. The term, which found renewed application after the 2008 financial crisis, refers to the domination of fiscal policy over monetary policy. It describes the extent to which budget deficits determine central bank actions. Once subjugated, the central bank’s role is to monetize the debt to keep interest rates low and inflate away the debt burden.
It’s hardly the role central bankers envisioned for themselves. After spending the last three decades delivering on their pledge of stable prices, the last thing they want to do is sacrifice their credibility, which has costs. Yet some economists think we may be getting near that point.
If interest rates rise and the Federal Reserve, in the normal conduct of monetary policy, has to sell securities from its huge portfolio, it could incur a loss. Too many losses mean less or no money to turn over to the Treasury Department. (The Fed earns interest on its securities and remits the balance, after paying operating expenses and interest on reserves, to the Treasury; in essence, to the taxpayer.)
Last year, the Fed remitted a record $88.4 billion to the Treasury after a $75.4 billion payment in 2011. Financing the U.S. government isn’t part of the Fed’s job description. Why should it be an issue if those remittances dwindle?
Because a bookkeeping issue will quickly turn into a political issue, according to Al Broaddus, former president of the Richmond Fed. Some lawmakers will forget about all the years of generous remittances and use a one-year loss as an excuse to curtail the Fed’s independence.
“At the end of the day, it looks like quantitative easing was the right thing to do,” Broaddus said. Would politicians have wanted the Fed to roll the dice and do nothing to avoid a potential bookkeeping loss? Probably not, he said.