International Spillovers of U.S. Fiscal Challenges

Expansionary fiscal policies have increased significantly following the subprime crisis in 2007 and the COVID-19 crisis, leading to fiscal dominance concerns, where a growing share of monetary authorities may be forced to deviate from policy targets to accommodate fiscal policies. Meanwhile, peripheral economies are constantly influenced by monetary and fiscal conditions in center economies, with the United States (U.S.) as the predominant force. In light of these developments, we examine the potential international spillovers from U.S. inflationary spells and growing fiscal concerns to the policy interest rates in Emerging Market Economies (EMEs) and Developed Economies (DEs). We introduce a new index of fiscal dominance concerns using Principal Components Analysis, and extend the concept to an international perspective, as opposed to previous literature examining fiscal dominance in a domestic environment. The results are confirmed by robustness analysis and show that greater U.S. fiscal challenges affect negatively the policy rates in both EMEs and DEs, with a greater impact observed in EMEs. Moreover, a low degree of financial repression is associated with more significant spillover effects from greater U.S. fiscal challenges.