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

A central bank states that it expects to keep its policy rate at the lower bound until inflation is sustainably at target. A risk manager at a bank holding a large portfolio of 5-year bonds interprets this as primarily operating through which channel?

Forward guidance works mainly through the signalling channel. By committing to keep rates low for longer, the central bank lowers the expected path of future short rates, which reduces the expectations component of longer-term yields such as the 5-year bond yield.

  1. ASignalling, by lowering expected future short rates and so the term structureCorrect
  2. BPortfolio rebalancing, by removing duration from the market
  3. CRaising the required reserve ratio for banks
  4. DDirectly fixing the 5-year yield through price controls

Explanation

Forward guidance works mainly through the signalling channel: it changes expectations of the future short-rate path, which lowers the expectations component of longer yields. Portfolio rebalancing is tied to asset purchases that remove duration supply. Guidance does not alter reserve ratios or fix prices.

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