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

A risk manager at a bank holding large sovereign bonds worries that the central bank may be forced to hold down yields as government debt rises. Which outcome would most clearly signal weakening central bank credibility under fiscal dominance?

Rising long-term inflation expectations and term premia despite higher policy rates signal that markets doubt the central bank can follow through on price stability because of fiscal pressures. The other outcomes, such as falling expectations or improving primary balances, indicate credibility or fiscal consolidation rather than fiscal dominance.

  1. ALong-term inflation expectations and term premia rise despite policy rate increasesCorrect
  2. BPolicy rates rise and long-term inflation expectations fall
  3. CGovernment primary surpluses increase and debt ratios decline
  4. DCentral bank balance sheet shrinks while inflation returns to target

Explanation

If markets doubt the central bank can tighten because of fiscal pressures, inflation expectations and term premia rise even as policy rates go up. The other options describe credible monetary dominance or fiscal consolidation, which would support stability.

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