The Congressional Budget Office just released its newest budget outlook. It isn’t pretty. The 2026 deficit is projected to hit $1.9 trillion and grow to $3.1 trillion in 2036. America’s slow-moving debt crisis shows no signs of waning.
But this isn’t solely a fiscal problem. It also has an unappreciated monetary dimension. If we’ve learned anything from the inflation surge of 2021–22, it’s that the boundary between fiscal and monetary policy can dissolve much faster than many economists once assumed. We had better come to terms with this quickly, or else money mischief and fiscal folly will become our new normal.
For years, concerns about “fiscal dominance” were largely theoretical possibilities discussed in graduate seminars. Things have changed. The pandemic response showed how fast large deficits and central bank balance sheets can become intertwined. Inflation is the most obvious consequence, but by no means the only one — nor perhaps even the most severe.
In normal times, monetary policy and fiscal policy are institutionally separate. Congress and the White House decide how much to tax and spend. The Federal Reserve controls the money supply and targets interest rates to stabilize prices and employment. The Fed is said to be “independent” because it can tighten policy even if doing so makes government borrowing more expensive. In truth, the Fed is not independent from political oversight. But this basic story is still a reasonable approximation of day-to-day operations.
Fiscal dominance flips that relationship. It occurs when large government deficits and debt burdens effectively constrain the central bank’s choices. Instead of focusing on price stability, the central bank must consider the government’s financing needs. Major monetary tightening might restore price stability, but it also drives up debt-service costs. If deficits are large enough and persistent enough, monetary policy becomes collateral damage.
We recently watched this happen in real time. In 2020 and 2021, Congress enacted extraordinary pandemic relief packages totaling trillions of dollars. Deficits reached levels not seen outside of world wars. At the same time, the Federal Reserve expanded its balance sheet dramatically, purchasing massive quantities of Treasury securities. The central bank defended these actions as necessary to stabilize financial markets. But the effect was unmistakable: deficits were effectively monetized.
To “monetize” a deficit means the central bank creates reserves to buy government debt, increasing the monetary base. When that expansion is large and persistent, it can spill into broader money growth, and hence aggregate demand. The result, combined with supply constraints and stimulus checks, was predictable: inflation climbed to 9 percent by mid–2022, the highest in four decades.
Yes, supply chains were tangled. Yes, transportation and energy prices spiked. But inflation of that magnitude required excess demand. And excess demand requires excess money and credit. The main culprit was the central bank’s financing of massive government spending.
The Fed ultimately reversed course, raising its interest rate target aggressively in 2022 and 2023. Inflation came down, but the damage was done. Fiscal matters have deteriorated even further since then.
Federal debt held by the public is near 100 percent of GDP. Annual deficits are projected to remain elevated for the foreseeable future, driven not by temporary emergencies but by structural imbalances: entitlement spending, demographic pressures, and insufficient revenues. With the low interest rates of the 2010s behind us for the foreseeable future, interest payments on the debt are becoming one of the fastest-growing components of federal spending.
That matters immensely for monetary policy. When rates rise, the Treasury must refinance maturing debt at higher yields. Higher yields mean higher annual interest costs. Higher interest costs mean larger deficits — which require more borrowing. The problem compounds.
In this unstable environment, the temptation to lean on the central bank becomes nearly irresistible. Political leaders may not explicitly demand monetization. But they don’t have to. Central bankers feel the pressure implicitly. When debt levels are high, tight monetary policy becomes fiscally painful.
Fiscal dominance subjugates monetary policy to political, and often partisan, needs. If markets begin to suspect that the Fed will ultimately accommodate deficits to avoid fiscal strain, inflation expectations can drift upward. Investors demand higher risk premia. The cost of stabilizing prices rises further.
The United States is by no means doomed. It has great productive capacity, deep capital markets, and global reserve-currency status. But those safeguards are not foolproof. At most, they are well-built storm walls — but the waves can topple them if they’re big enough.
Thanks not merely to an excessive pandemic response but also to decades of profligacy, the barrier between fiscal demands and monetary accommodation is getting very thin. Crossing it will create major economic pain. Once inflation takes hold, restoring credibility is expensive. And subjugating financial markets to government spending ambitions will destroy large amounts of wealth by diverting capital from productive to unproductive projects.
Sound money ultimately requires sound public finances. A central bank cannot permanently offset fiscal excess without courting inflation and facilitating economy-wide allocation problems. Nor can it remain focused on price stability if tightening policy threatens fiscal sustainability.
Only Congress can fix this. There’s no option besides spending less. If that sounds ominous, it should. The legislature has shown no appetite for any kind of fiscal reform. Yet any portfolio of policies to solve the problem must include it. So long as elected officials continue to treat the public purse with contempt, price stability and economic efficiency are at risk.
