FRM Part II · FRM Exam Part II · Monetary and Fiscal Policy: Safeguarding Stability and Trust
A central bank faces a surge in inflation while its government's debt is high and a portion of banks' assets consists of long-dated government bonds. Which statement best describes the main financial stability trade-off of aggressively raising policy rates?
Tightening policy fights inflation but lowers the market value of existing long-dated bonds and raises refinancing costs for governments. Banks holding such bonds can suffer losses, so price stability and financial stability objectives can conflict, particularly when public debt is already high.
- AHigher rates reduce inflation but cause mark-to-market losses on bond holdings and higher government debt-servicing costs, which can strain banks and sovereign financesCorrect
- BHigher rates raise the market value of existing long-dated bonds, strengthening bank balance sheets and eliminating the trade-off
- CHigher rates have no effect on government financing costs because debt is issued at fixed coupons forever
- DHigher rates always lower inflation expectations immediately, so no stability cost arises
Explanation
Rate increases lower the prices of existing fixed-rate bonds, creating losses for holders such as banks, and raise the cost of refinancing government debt. This creates tension between the price stability and financial stability objectives. The option claiming bond values rise has the price-yield relationship reversed.
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