A generation of investors learned a simple rule. Inflation is a monetary problem. Central banks control the money supply, so central banks control inflation. Raise rates to cool it, cut rates to revive it. That rule worked reasonably well for a long time, and it shaped how almost everyone thinks about the economy. It is now incomplete, and acting on it alone can lead you badly astray. The shift, which Lyn Alden has described clearly, is from a monetary world to a fiscal one.

Here is the distinction. Monetary policy works through the banking system. When a central bank lowers rates, it encourages banks and borrowers to create more credit, which can stimulate the economy and lift prices. But this channel depends on the private sector wanting to borrow. When households and companies are already heavily indebted or cautious, cutting rates pushes on a string. The money does not flow into the real economy in the way the textbook promises.

Fiscal policy is different. When a government runs a large deficit, it spends money directly into the economy. That spending lands in people’s bank accounts as income, whether or not anyone wants to borrow. It bypasses the credit channel entirely. In an era of persistent large deficits, driven by demographics, defense, energy transition, and interest on existing debt, the government becomes the dominant source of new money entering the system. Inflation then responds to the fiscal impulse more than to the setting of interest rates.

This has a strange consequence that catches many investors off guard. Higher interest rates, which are supposed to fight inflation, also increase the government’s interest payments on its enormous debt. Those payments are themselves a form of fiscal spending, flowing to bondholders. So beyond a certain level of debt, raising rates can actually inject money into the economy through the interest channel, partly offsetting the intended cooling effect. The tool starts to work against itself.

The takeaway is not that monetary policy is irrelevant. It is that the fiscal side now sits in the driver’s seat, and any analysis that watches only the central bank is watching the wrong dashboard. To understand inflation and the direction of the currency, watch the deficits, the maturity structure of the debt, and the political appetite for spending. In a fiscally dominant world, the treasury matters more than the central bank, and the sooner an investor internalises that, the clearer the landscape becomes.

The Fiscal Dominance Threshold

There is a debt-to-GDP level beyond which the central bank’s independence becomes a polite fiction. When government debt is large enough that even modest interest-rate increases materially worsen the fiscal deficit, the central bank faces a choice between fighting inflation with higher rates and blowing up the sovereign’s debt dynamics. The historical record is unambiguous about which choice wins: the fiscal authority dominates, and the central bank accommodates, because the alternative is a sovereign funding crisis that is worse than the inflation it was trying to cure.

The practical implication for investors is that the policy response function changes at this threshold. In a monetarily dominant regime, the central bank can tighten as much as inflation requires. In a fiscally dominant regime, the tightening is capped by the sovereign’s ability to service its debt, which means inflation can persist at levels above target for longer than any model calibrated to the previous regime would predict. Recognising which regime you are in is more important than forecasting the next rate decision.