FRM Part II · FRM Exam Part II · Monetary and Fiscal Policy: Safeguarding Stability and Trust
A government pressures its independent central bank to buy newly issued sovereign bonds to cap borrowing costs while inflation exceeds target. Which assessment best describes the likely consequence for the central bank's mandate and for investors?
Fiscal dominance risk rises. Buying bonds to cap government borrowing costs while inflation is above target signals that monetary policy serves fiscal needs, so inflation expectations can de-anchor, risk and term premia may increase, and the central bank's credibility in its price-stability mandate erodes.
- AFiscal dominance risk rises: inflation expectations may de-anchor, the inflation risk premium and term premium on government debt can increase, and credibility of the price-stability mandate erodesCorrect
- BMonetary dominance is strengthened because balance sheet expansion tightens policy
- CSovereign yields fall permanently with no effect on inflation expectations
- DThe central bank's independence is unaffected since purchases are market-based
Explanation
Purchases aimed at funding the government when inflation is above target signal that monetary policy is subordinate to fiscal needs, which is fiscal dominance. Expectations may de-anchor, raising inflation and term premia and undermining credibility. Balance sheet expansion is not tightening, and any yield fall would not be permanent.
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