CFA Level I · CFA Level I Exam · Monetary Policy
Market participants believe that a central bank's inflation target is not credible and expect a policy rate cut to cause higher inflation. The most likely effect on long-term nominal bond yields following the rate cut is that they:
Long-term nominal yields would most likely rise. Without credibility, a rate cut raises expected inflation, and investors demand a higher inflation premium on long bonds, which can offset the lower short rate and weaken the policy's effect.
- Afall sharply because the policy rate is lower
- Bremain unchanged because policy affects only short rates
- Crise because of higher expected inflationCorrect
Explanation
Long-term nominal yields include an inflation expectations premium. If a cut lowers credibility and raises expected inflation, long yields can rise despite the lower short rate, which limits policy effectiveness. Long yields are not tied only to the current policy rate.
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