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

A central bank has held a very large bond portfolio financed by interest-bearing reserves after years of QE. It now raises its policy rate sharply. Which risk is most directly created for the central bank and, indirectly, for fiscal authorities?

The central bank faces lower remittances or net losses. After QE it holds long fixed-rate bonds funded by reserves that pay the policy rate, so a sharp rate rise lifts its interest expense above asset income, reducing transfers to the government and potentially straining fiscal trust.

  1. ALower remittances or net losses, as interest paid on reserves exceeds the yield on its fixed-rate bond holdingsCorrect
  2. BHigher seigniorage because reserves become cheaper to hold
  3. CGuaranteed capital gains on the bond portfolio because yields fall when policy rates rise
  4. DElimination of interest rate risk because the bonds are risk-free

Explanation

QE leaves the central bank with long fixed-rate assets funded by floating-rate reserves. When the policy rate rises, interest expense on reserves rises while asset income stays fixed, reducing remittances to the treasury or generating losses. Rising rates cut bond values rather than raising them.

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