Fiscal Dominance: Structural Debt Expansion, Monetary Growth, and Rising Risk Premiums

Overview

In these scenarios, central banks face pressure to accommodate fiscal conditions by sustaining low interest rates or expanding the monetary base, often at the cost of price stability.

This environment presents significant implications for investors and market participants. With gross federal debt now exceeding $33 trillion, and the money supply (M2) at all-time highs, the rate of growth in public liabilities and liquidity is increasingly decoupled from real economic output — raising questions about long-term debt sustainability and inflation dynamics.

Persistent Deficits and Structural Imbalances

The U.S. federal government has recorded multi-trillion-dollar deficits for five consecutive years, beginning with the 2020 COVID-19 fiscal response. While the 2020 and 2021 deficits of $3.1T and $2.8T respectively were largely pandemic-related, subsequent deficits have remained high: $1.4T (2022), $1.7T (2023), and $1.8T (2024). The deficit-to-GDP ratio stands at 6.3%, a level generally associated with crisis periods, not economic expansions.

The persistence of high deficits, despite a recovering economy and low unemployment, reflects long-term structural imbalances — particularly in entitlement spending, discretionary expenditures, and rising net interest obligations. The fiscal outlook is further constrained by ongoing political challenges surrounding taxation and expenditure reform.

Debt Absorption and Ownership Trends

As of 2024, approximately 80% of U.S. gross federal debt is held by the public, with the remaining 20% consisting of intragovernmental holdings such as trust funds. Public holders include both domestic and international investors.

Over time, the composition of public debt ownership has shifted heavily toward domestic entities. In 1970, foreign holders accounted for only 5% of the federal debt held by the public. By 1995, that figure rose to 23%. In 2024, it stands at approximately 30%, reflecting a partial reversal driven by foreign divestment and increasing domestic absorption.

The largest domestic holders include the Federal Reserve ($4.6T), mutual funds ($4.5T), pension funds, insurance companies, state and local governments, and other institutional investors. These participants provide a stable base of funding but are also directly exposed to interest rate risk and potential real return erosion under inflationary conditions.

M2 Expansion and Monetary Backdrop

Since early 2020, the U.S. money supply (M2) has expanded at a historically unprecedented pace, increasing by over $6 trillion in less than three years. While the pace of expansion slowed following monetary tightening in 2022–2023, the absolute level of liquidity in the system remains significantly elevated compared to pre-pandemic norms.

This expansion was largely driven by the Federal Reserve’s purchase of Treasury securities under quantitative easing programs, which effectively financed deficit spending through base money creation. The resulting decoupling between monetary supply growth and real GDP introduces inflationary tail risk — particularly if fiscal deficits persist and investor demand for Treasuries weakens.

Credit Downgrade and Risk Reassessment

In November 2023, Moody’s Investors Service downgraded its outlook on U.S. sovereign credit. The agency cited rising debt-to-GDP ratios, the absence of a credible fiscal consolidation plan, and elevated political gridlock. The U.S. now maintains a split rating, with Fitch having already downgraded the U.S. to AA+ in 2023 and S&P having done so in 2011.

The rating agencies have emphasized that continued high borrowing at elevated interest rates risks materially weakening the federal government’s fiscal position. The outlook downgrade does not yet indicate a credit event, but it introduces additional scrutiny from institutional investors, who may reassess required yields or hedge sovereign exposure more actively.

Debt Growth Relative to Output

Federal debt growth has increasingly outpaced economic expansion. Since 2000, gross federal debt has risen from $6 trillion to over $33 trillion, with debt held by the public now exceeding $26 trillion. The rise in debt obligations has been especially sharp post-2008, coinciding with crisis-driven spending and more accommodative monetary policy regimes.

The widening gap between debt levels and GDP suggests growing leverage in the federal balance sheet. Higher interest rates further amplify the fiscal burden, as a larger share of the federal budget is allocated to debt servicing.

Policy Uncertainty and Investor Positioning

A May 2025 Reuters article highlighted a shift in market behavior in response to rising policy uncertainty and deteriorating debt fundamentals. Market participants have begun to hedge sovereign exposure more actively by:

• Increasing allocations to Treasury Inflation-Protected Securities (TIPS)
  

• Utilizing bond futures and interest rate swaps
  

• Adjusting portfolio duration and asset allocation to reflect higher volatility expectations

The underlying concerns center on the possibility that the Federal Reserve may eventually face constraints in raising rates if doing so triggers fiscal stress. This potential conflict between inflation control and debt affordability is a core element of fiscal dominance theory.

Evidence of Fiscal Dominance Characteristics

Several macroeconomic developments since 2020 align with conditions typically associated with fiscal dominance. These include persistent and large-scale federal deficits during non-recessionary periods, a rapid rise in public debt relative to GDP, elevated inflation coinciding with recent monetary expansion, and increased reliance on central bank purchases of sovereign debt.

In such regimes, monetary policy is not fully independent; rather, it is constrained by the fiscal authority’s need to fund spending. Central banks may be limited in their ability to raise rates aggressively or reduce balance sheets, as doing so could significantly increase sovereign borrowing costs and destabilize financial markets.

Forward-Looking Observations

Debt Sustainability

Rising net interest payments — now among the fastest-growing federal expenditures — could crowd out other budget priorities, particularly if nominal yields remain elevated. Investors may track real interest cost trajectories relative to revenue growth when assessing sovereign exposure.

Term Structure Risk

Yield curve dynamics may reflect increasing term premiums, as long-term investors demand compensation for fiscal and inflation uncertainty. This could impact pricing for long-duration fixed-income assets, infrastructure projects, and public-private partnerships.

Central Bank Policy Flexibility

There is increasing attention on whether the Federal Reserve can maintain inflation-targeting independence while accommodating rising Treasury issuance. Investors may evaluate future Fed guidance in light of fiscal policy developments.

Asset Allocation and Portfolio Impact

Persistent fiscal dominance would present implications for portfolio construction — particularly in fixed income, real assets, and inflation-sensitive sectors. Hedging strategies, alternative yield sources, and relative value positioning may become more critical.

Conclusion

The U.S. fiscal and monetary environment is undergoing a structural shift. Rising debt levels, sustained deficits, and increased reliance on monetary support to absorb Treasury issuance reflect characteristics of a system influenced by fiscal dominance. With the money supply (M2) elevated and debt outpacing output, macroeconomic conditions may increasingly embed longer-term inflationary pressure and credit risk premiums.

Recent credit rating outlook downgrades, shifting investor hedging patterns, and term structure adjustments suggest that markets are beginning to price these risks more explicitly. Stakeholders across institutional investing, private equity, and public markets may wish to monitor these dynamics closely, as they influence long-term valuations, borrowing conditions, and financial stability indicators.

Sources & References

FRED. (2025). Who holds US national debt? https://fredblog.stlouisfed.org/2025/03/who-holds-us-national-debt/ 

Peterson Foundation. (2025). The Federal Government Has Borrowed Trillions. Who Owns All that Debt? https://www.pgpf.org/article/the-federal-government-has-borrowed-trillions-but-who-owns-all-that-debt/ 

PE150. (2025). Moody’s Downgrades U.S. Credit Rating Over Fiscal Risk and Inflation. https://www.pe150.com/p/moody-s-downgrades-u-s-credit-rating-amid-rising-fiscal-concerns-1830 

PE150. (2025). M2 Infinity and Beyond. https://www.pe150.com/p/m2-infinity-and-beyond-99c8 

Reuters. (2025). Policy uncertainty fuels rise in U.S. government debt hedging. https://www.reuters.com/business/finance/policy-uncertainty-fuels-rise-us-government-debt-hedging-2025-05-09/ 

TJR. (2025). The national debt: How and why the US government borrows money. https://journalistsresource.org/economics/public-debt/ 

U.S. Department of the Treasury. (2025). Financing the Government. https://home.treasury.gov/policy-issues/financing-the-government