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FRM Part II · FRM Exam Part II · Monetary and Fiscal Policy: Safeguarding Stability and Trust

A central bank announces that it will keep its policy rate at 0.25% until unemployment falls below 5% and inflation is projected above 2%. Markets had previously priced a rate rise in 12 months, and after the announcement the 2-year yield falls. Which interpretation is most consistent with this outcome?

The fall in the 2-year yield is consistent with forward guidance lengthening the expected period of low rates. Markets revised down the expected path of future short-term policy rates, which lowers medium-term yields, rather than the bank changing its target or shrinking its balance sheet.

  1. AThe announcement was a signal that the bank will lower its inflation target permanently
  2. BThe announcement raised the expected duration of low rates, lowering the expected path of short ratesCorrect
  3. CThe announcement lowered the term premium only, with no change in expected short rates
  4. DThe announcement reduced the central bank's balance sheet

Explanation

State-contingent forward guidance works by changing expectations of the future policy rate path. If markets had priced a rise in 12 months and the 2-year yield falls, expected short rates were revised down. Term premium alone would not explain a shift tied to the rate-path commitment, and nothing here implies balance sheet shrinkage.

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