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

A risk manager is assessing how forward guidance can lose effectiveness. Which scenario best illustrates a credibility problem for forward guidance?

Forward guidance fails when markets doubt the central bank will keep its promise, for example if they expect it to tighten earlier once inflation rises. Then expected short rates and long yields do not move as intended, showing that effectiveness rests on credibility and time consistency.

  1. AMarkets believe the commitment and adjust rate expectations accordingly
  2. BThe central bank signals rates will stay low, but markets doubt it will honour this once inflation rises, so long yields do not fallCorrect
  3. CThe central bank publishes its projections with wide uncertainty bands
  4. DThe central bank links its guidance to explicit economic thresholds

Explanation

Forward guidance depends on credibility that the commitment will be kept even when conditions tempt a reversal (time inconsistency). If markets expect the bank to renege when inflation rises, expected rates do not fall and long yields do not respond. Thresholds and projections generally support, not undermine, credibility.

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