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

A central bank with a 2% inflation target observes that inflation has been 5% for a year, while medium-term inflation expectations remain anchored near 2%. A risk analyst assessing the credibility channel would most reasonably conclude that:

Anchored medium-term expectations show the public trusts the target, which limits second-round effects such as wage-price spirals. The central bank therefore generally needs less tightening to restore low inflation than if expectations had de-anchored, illustrating the value of credibility built through a clear mandate.

  1. AThe inflation target has been abandoned by the public
  2. BCredibility is helping limit second-round effects, so the central bank may need less tightening than if expectations were unanchoredCorrect
  3. CThe central bank must raise rates by more than if expectations had de-anchored
  4. DInflation expectations are irrelevant to policy transmission

Explanation

Anchored expectations indicate the public believes the target will be restored, which reduces wage-price spirals and the tightening needed to bring inflation down. De-anchored expectations would require more tightening, not less.

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