Fiscal dominance refers to a situation in which a central bank's monetary policy becomes influenced, to a greater extent than warranted, by concerns surrounding public debt sustainability.

Over recent months, the euro area has entered a particularly delicate environment. Driven by the surge in energy prices, euro area inflation has reached 3.3% year-on-year, while economic activity remains subdued and public debt dynamics are coming under increasing pressure.

The rise in long-term rates observed throughout 2026 accelerated sharply in August. The 10-year German Bund yield exceeded 3.35%, its highest level since 2011, while euro swap rates also moved significantly higher. Any additional rate hikes by the ECB would inevitably weigh on the financing and refinancing conditions of both public and private borrowers.

At this stage, it can reasonably be argued that the ECB is not constrained by fiscal dominance

The ECB remains firmly in a regime of monetary dominance.

Following the 25-basis-point rate increase implemented in June, markets are pricing in three additional hikes, which would bring the deposit facility rate to 3% within the next year. Expectations for further tightening have continued to rise since the outbreak of the Iranian conflict and the ongoing navigation restrictions in the Strait of Hormuz.

Looking ahead, the key question concerns the ECB's response to a significant and persistent inflation shock occurring in an environment characterized by high public debt and weak growth.

If elevated energy prices persist and generate second-round effects, the ECB will face a difficult trade-off between maintaining a sufficiently restrictive policy stance to bring inflation back toward its medium-term target of just below 2%, and managing the financial consequences of higher rates, particularly in terms of economic growth and financial stability, including the fiscal positions of the most vulnerable European economies.

This is where the grey area of fiscal dominance emerges: public finances do not directly dictate monetary policy, yet the very real budgetary constraints faced by governments may gradually influence and restrict the ECB's reaction function.

The Real Risk Lies at the Long End of the Curve

The ECB controls short-term interest rates but has far less direct influence over long-term rates. If investors begin to believe that the ECB is placing excessive weight on the budgetary and financial constraints of sovereign borrowers at the expense of its inflation-fighting mandate, they may demand a higher risk premium on long-term bonds.

The paradox is that fiscal dominance could ultimately lead to higher long-term rates despite smaller increases, or even stability or declines, in short-term policy rates.

The yield curve could therefore steepen significantly, driven by the combination of a monetary policy perceived as overly accommodative and a growing risk premium embedded in long-term yields.

This risk is not unique to the euro area. Similar concerns exist in both Japan and the United States, giving the issue a global dimension, although the underlying drivers differ significantly across economic regions.

It should be noted, however, that such an outcome is not inevitable. A prolonged energy shock could also weigh heavily on economic activity and reinforce expectations of slowing growth or recession. In that case, downward pressure on long-term yields arising from deteriorating growth prospects could partly offset, or even temporarily exceed, the upward pressure stemming from a higher term premium.

The Return of QE: A Particularly Delicate Response

Should long-term yields continue to rise alongside an increase in risk premia, the ECB could be tempted to intervene in order to contain a disorderly rise in long-term yields or excessive fragmentation across sovereign bond markets.

However, a return to Quantitative Easing (QE) in an environment where inflation remains elevated would raise significant credibility concerns.

Would such intervention still be perceived as a tool aimed at preserving the transmission of monetary policy, or would it instead be viewed as an attempt to limit the rise in government borrowing costs?

It is precisely at that point that the boundary between monetary policy and fiscal dominance would become most difficult to maintain.

Conclusion

Fiscal dominance is not currently an established regime within the euro area. Nevertheless, the combination of rising inflation and a sharp increase in long-term rates represents an important test of the credibility of the ECB's monetary dominance framework.

The scenario to monitor is therefore not truly that of an overly accommodative ECB. Rather, it is the risk of an ECB perceived as accommodative because it becomes progressively constrained by the fiscal and financial consequences of maintaining a restrictive policy stance.

In such circumstances, the market outcome would not necessarily be lower long-term rates. On the contrary, a loss of confidence in the ECB's commitment to price stability could trigger a higher term premium, a steeper yield curve and increased rate volatility, even while policy rates remain contained.

The ECB could then face a particularly difficult dilemma: raise rates sufficiently to preserve its anti-inflation credibility, at the risk of exacerbating sovereign stress and widening credit spreads, or limit monetary tightening, at the risk of allowing term premia on long-term rates to rise further.

The combination of a monetary policy constrained at the short end of the curve and a rising term premium at the long end could become one of the major market risks facing the euro area over the coming quarters. Indeed, uncertainty surrounding the ECB's reaction function could itself become a significant source of volatility across fixed income markets.

As we have regularly highlighted since the beginning of the year, clouds continue to gather over long-term interest rates, and any further escalation of the conflict in the Strait of Hormuz could have severe consequences for global bond markets.