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

A central bank's QE programme has expanded its balance sheet substantially, and the policy rate is later raised. Which risk to the central bank and, indirectly, to fiscal authorities is most directly associated with this exit?

The key exit risk is that the central bank pays higher floating interest on reserves while earning fixed low coupons on QE bonds, which can produce losses and weaken remittances to the government. Rising yields also reduce the market value of the holdings.

  1. AInterest expense on reserves can exceed income on low-yielding bonds held, producing lossesCorrect
  2. BBond holdings automatically rise in value as yields increase
  3. CReserves held by banks cease to bear any interest
  4. DGovernment debt service costs fall because bond yields rise

Explanation

After QE the central bank holds long-term fixed-rate bonds funded by floating-rate reserves. When the policy rate rises, interest paid on reserves rises while asset income stays fixed, and higher yields lower bond market values, which can create losses. Bond values fall, not rise, and rising yields raise rather than lower government financing costs.

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