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

A central bank raises its policy rate by 100 basis points while government debt is high and mostly short-term or floating-rate. Which risk is most directly heightened by this conventional tightening, as emphasised in discussions of monetary and fiscal interaction?

The key risk is higher government debt-servicing costs. When debt is short-term or floating-rate, a rate hike quickly raises interest expense, worsens fiscal sustainability and can erode confidence in the central bank's independence and its inflation-fighting resolve.

  1. AHigher debt-servicing costs that strain fiscal sustainability and may weaken confidence in the policy frameworkCorrect
  2. BAutomatic reduction in the sovereign's interest bill because deficits shrink instantly
  3. CElimination of term premia across all maturities
  4. DLower interest income for the central bank's commercial bank counterparties

Explanation

With short-term or floating debt, higher policy rates pass quickly into interest costs, worsening deficits and raising sustainability concerns that may pressure the central bank. The interest bill does not fall, term premia are not eliminated, and banks' reserve income typically rises.

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