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

A risk manager analyses why central banks with financial stability responsibilities sometimes face conflicts with their price stability objective. Which situation best illustrates such a conflict?

The conflict appears when inflation is above target but sharp rate increases would stress leveraged borrowers and banks. Price stability calls for tightening while financial stability argues for caution. The other scenarios involve aligned objectives or no tension between them.

  1. AInflation is below target and financial conditions are weak, so rates are cut
  2. BInflation is above target, but raising rates sharply would stress highly leveraged borrowers and bank balance sheetsCorrect
  3. CInflation is on target and the banking system is well capitalised
  4. DInflation is stable and the central bank publishes its forecasts

Explanation

Conflict arises when the rate action needed for price stability threatens financial stability. Above-target inflation calls for tightening, but tightening could strain leveraged borrowers and banks. The other cases show no tension between the objectives.

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