In today’s episode of Bridge talks Business, Analyst Brendan Larsen explains fiscal dominance, and how there are signs that this is beginning to creep into the US administration. He talks through why this is a risk, and why it is important for Central Banks to retain independence in setting policy that achieves their inflation mandate.
Watch.
Listen.
Click here to download the MP3 file or listen to the podcast on your favourite platform:
Read.
Bridge talks Business: 5 August 2025
Episode Transcript
Ryan Bridge
Kia ora and welcome to Episode 44 of Bridge talks Business with Milford. Governments around the world have a big problem on their hands. Debt. They’ve been splashing the cash during and post-Covid, as we all know, taking on piles of extra borrowing. Interest rates have been high to tame inflation, and that means the cost of servicing that debt goes up.
This means deficits, and it means friction between central banks and governments. One wants to spend and borrow cheaply. The other wanting to tackle inflation. Brendan Larsen from Milford will talk us through this today and what it means for investors, for us. But first, here’s your top five business bits.
- The US labour market is not as healthy as investors expected. Its job creation this month and in months prior has been sluggish. Yet the unemployment rate barely changed as immigration crackdowns in the US are capping the size of the workforce there.
- The US Federal Reserve didn’t flinch and left interest rates unchanged, awaiting more data on how tariffs are impacting inflation before deciding on a next move. Investors overwhelmingly expecting a cut at the next meeting. That’s in September.
- US GDP released last week for the second quarter revealed an economy that remains a bit limp, growing at around 1% underlying pace, and it’s a noticeable step down from the 2% pace of last year. GDP growth is expected to remain sluggish for the remainder of this year at least.
- Quarterly earnings reports from big tech companies last week confirming that corporate spend on AI continues apace, as the beneficiaries of this spend released blowout numbers. Stock moves were relatively muted though, as it looks like investors largely expected these outcomes.
- This week, a relatively quiet week on the data front, with US services sector business surveys and the Bank of England policy meeting, the key events of note.
Right. It is time for our feature interview for this episode. Bit of tension happening around the world, and it’s not just the American government, but you’ve got central banks, those who are controlling interest rates, at loggerheads with central governments, those who are taking on extra debt, particularly after and in the wake of Covid.
So what does all this mean for investors? What does it mean for us? Joining me on this episode is Brendan Larsen, an Analyst at Milford. Just a reminder, this segment is informational only and should not be considered financial advice. Brendan, welcome back to the podcast.
Brendan Larsen
Good to see you. Thanks for having me.
Ryan Bridge
So, let’s talk about this friction between central banks and governments. Governments have got all the debt, they’re paying the interest. And the central banks are setting the interest rates basically, aren’t they? So there’s friction there.
Brendan Larsen
Yeah. That’s right. And that interaction between the government and the central bank is really important for economic outcomes. In most developed economies, including the US, we operate under what’s called a monetary dominance regime, which really just means, like you say, central banks are the ones that target inflation and set policy to address that part of their mandate.
And governments ensure debt sustainability. Fiscal dominance, on the other hand, occurs when monetary policy becomes subordinated to the needs of government finance. So when government debt and deficit levels become so big, monetary policy is forced to adjust basically, and keep the government solvent.
Ryan Bridge
Okay, so there’s tension there. Does it matter who’s in charge, or which side is the more dominant one?
Brendan Larsen
Yeah, it’s a good question. And like I say, the current dynamic is one where the central bank independently sets policy to manage that inflation-part of their mandate. So when inflation is above target, central banks raise interest rates to restrictive levels to try and tame inflation. And the opposite is true when inflation is below the target level. If instead, we entered this regime where fiscal deficits threatened the solvency of a country, and central banks were forced to keep rates lower than they would, based on what those economic conditions were, then that threatens inflation and could really result in a spiral where inflation becomes out of control.
Keeping rates too low encourages spending over saving because the interest rates you’re getting on your cash are much lower. And it also encourages people to go up the risk curve in pursuit of higher returns. And so both of those things are inflationary. So you can see that it is really important for the central bank to be the one that does target inflation, independent of what government policy is.
Ryan Bridge
So, that’s the monetary dominance side of it. Have we ever been in a situation where the government fiscal side has been the dominant one?
Brendan Larsen
Yeah, we have Ryan. But importantly that’s happened in periods typically that have been during a crisis. So for example, during World War Two the Federal Reserve operated under an explicit agreement with Treasury to cap interest rates, and that was really to support wartime financing. Ultimately, that did exacerbate the inflationary pressures during the time. And in more recent periods, we’ve seen governments around the world issue a lot of debt during the Covid period to help the economy get through that period. And central banks were forced to expand their balance sheets materially to absorb all of this government debt.
So, again, sort of blurring the lines between whether the central bank is pursuing their inflation mandate or helping the government’s finances. Again, both of these happened during periods of crisis. So despite the material economic consequences, you can understand why that occurred. I think one better example of pure fiscal dominance that occurred during a period that wasn’t necessarily a crisis was the Liz Truss moment a few years ago in the United Kingdom, where she embarked on a bunch of new tax cuts that weren’t funded by spending cuts.
So, that saw government bonds really decline quite materially as investors lost confidence in the UK government’s finances and, as a result, the Bank of England were forced to intervene and stop their own selling of government bonds to actually buy government bonds. Again, this looks like a backstop to poor government policy.
Ryan Bridge
So, obviously it’s important. Sounds important, but why is it important? You know, which side of the equation this falls on.
Brendan Larsen
Yeah. Look, so it’s important now because many countries around the world have accumulated a lot of debt. So, the US is probably the best example of this. They’ve got a deficit of over 6% now and isn’t expected to make any real progress with that, given current policy.
And in the US, historically, governments ran deficits as a countercyclical tool. So, stimulating the economy during weak periods and then pulling back during periods of growth. In the last decade, the deficit has remained persistently large, particularly in the US, but in many other countries as well. And the reason for that is it’s become more of a structural reason than a cyclical reason.
The population is aging. We’re having to spend more on social security, more on healthcare. And as a result of this higher debt load and higher interest costs, governments are also spending a lot more on interest. And in fact, interest expense in the US is now more than Medicare and Defence spend combined.
Ryan Bridge
Wow. Which is why Donald Trump is getting so agitated at Jerome Powell – because he’s forking out all this money on interest on the debt.
Brendan Larsen
Yeah, I mean, it certainly looks that way. It’s hard to tell for sure. But this administration is certainly creeping closer to fiscal dominance. So you’re right. Trump has repeatedly posted that if the Federal Reserve lowered rates by 200 basis points, he’d save $X billion in interest costs every year. And that is a really dangerous path.
Because we could see, you know, if it shifted towards that where the fed is forced to reduce rates to help manage government finances. Again, we could get into this period of more inflation risks in future periods.
Ryan Bridge
All right. So that’s Trump having his 2 cents worth. There are also some other things happening behind the scenes in America to do with trying to get that burden of the debt away from central banks and on to private banks.
Brendan Larsen
Yeah, that’s right. So as you say, in addition to Trump saying the Fed is costing us too much money, there are other signs that we’re seeing of this morphing or crossing of the line between this fiscal and monetary side. So, there’s been changes to bank regulations to effectively allow banks to buy more treasuries in the US. So again, someone to monetise this government debt.
There’s been changes to stablecoin regulations, which again has short term government debt in the US backed by it. So again increasing demand for government debt. That can continue to issue but have someone buying that. I mean there’s also been senators in the US talk about removing interest on reserves in the US. This is an extension of Trump wanting to reduce the interest burden of the US. This would directly reduce the interest burden. So all of those things, politicians and fiscal policy, looking to morph over towards that monetary side and manage this big debt burden that the US have.
Ryan Bridge
So from the perspective of somebody managing these funds, how do they interpret all this? How do they see the wood through the trees a bit?
Brendan Larsen
Yes. I would say that I don’t think there’ll be a clear message that we’re exiting this monetary dominance into a fiscal dominance regime. But there are growing signs, and I think there are growing risks of this happening. So for us thinking about this, it’s certainly in our building of portfolios at the moment. For example, we continue to be really wary of government bonds in the US, particularly at the long end of the curve, given these implications we’ve just talked about. The other asset that would do really well in this sort of environment, where a central bank was forced to keep rates too low and we had more inflationary pressures, more concerns around governments, that would lead to a weaker US dollar and ultimately be really good for real assets like gold.
Ryan Bridge
So depending on how far down this track we go, will determine how valuable some of those classes could be?
Brendan Larsen
Yeah, that’s right.
Ryan Bridge
That was Brendan Larsen, an Analyst at Milford, telling us all about fiscal dominance. I bet you didn’t know what that meant before today. I certainly didn’t, but fascinating discussion as always. Don’t forget you can like, follow and subscribe the podcast where ever you like to listen. Until next week, keep investing in yourselves.
Missed previous episode? Don’t worry! Click here to catch up now.
