With a Bank of Japan rate hike expected at the September Monetary Policy Meeting, some observers warn that leaving the fiscal deficit unchecked could reduce the flexibility of monetary policy and that fiscal dominance could intensify inflationary pressures in the future.
There are doubts over whether the Bank of Japan can raise interest rates as much as necessary to curb inflation, and Japan's fiscal deficit has given rise to the problem of fiscal dominance. Fiscal dominance refers to a situation in which fiscal deficits and government debt become so large that the central bank is forced to take the financing of government debt into account, making it difficult to pursue monetary policy that gives top priority to price stability. This article explains the concept and the mechanism behind its effects.
The reasons fiscal dominance arises are said to include the two ways in which the government can finance a fiscal deficit: issuing government bonds and monetisation. Monetisation involves the central bank directly underwriting newly issued government bonds and supplying currency to the government, but in Japan, Article 5 of the Public Finance Act prohibits direct underwriting of new government bonds in principle. The Bank of Japan's ordinary purchases of government bonds involve buying bonds in the market, which does not directly increase the amount of banknotes in circulation but does increase financial institutions' current account deposits.
Unpleasant monetarist arithmetic, which sets out the key points of this theory, holds that even if efforts are made to contain the fiscal deficit and the central bank immediately tightens the money supply, inflation may not be permanently contained. It shows that, depending on the conditions, current monetary tightening can in some cases lead to even higher inflation in the future.