As the Federal Reserve considers the monetary policy methods it will use to bolster an economic recovery from the ongoing COVID-19 pandemic, Fed chair Jerome Powell told the U.S. Senate Banking Committee on June 16, 2020, that “we are committed to using our full range of tools to support the economy in this challenging time.”
The central bank has already reduced interest rates to near zero and used two of the same tools deployed during the 2007-09 Great Recession: forward guidance (using agency forecasts to influence current and future market expectations and economic conditions) and quantitative easing (buying government bonds or other financial assets in order to inject money into the economy).
What’s next? After some speculation about negative interest rates, Fed officials are now talking instead about a policy called yield curve control (also sometimes called interest rate caps). This policy seeks to hold down longer-term interest rates by capping what the government pays on its debt. The Federal Reserve is just the latest national central bank to give serious consideration to yield curve control, following countries such as Japan and Australia.
The yield curve is the relationship between rates on bonds of varying durations. Investors generally demand a higher yield for holding longer-term debt, meaning that the curve is normally upward-sloping. Usually, central banks manage monetary policy through short-term rates only. The Fed, for instance, creates incentives to keep overnight borrowing within a range it specifies—this is known as the Fed Funds Rate. With yield curve control, the central bank also sets a target yield for one or more specific maturities of government debt.
Most often, the Fed steers the economy by raising or lowering very short-term interest rates, such as the rate that banks earn on their overnight deposits; but with a policy of yield curve control the Fed targets some longer-term rates and pledges to buy enough long-term bonds to keep the rates from rising above their targets. This allows the Fed to stimulate the economy if it appears bringing short-term rates to zero is not enough. This approach could also help prevent a recession or lessen the impact of a downturn.
Some Fed governors as well as some former Fed chairs have suggested that the central bank ought to consider yield curve control. It could help strengthen the Fed’s forward guidance, which currently says that rates will remain near zero until the central bank’s Federal Open Market Committee (FOMC) is confident that the economy is on track to achieve its maximum employment and price stability goals after the pandemic.
How Does It Work?
Quantitative easing, which includes the trillions of dollars in bond-buying the Fed pursued during the Great Recession and throughout 2020, is different from yield curve control in one major respect. Quantitative easing deals in quantities of bonds; yield curve control focuses on prices of bonds. Under quantitative easing, a central bank might announce that it plans to purchase, for instance, $1 trillion in U.S. Treasury securities. Because bond prices are inversely related to their yields, buying bonds and pushing up their price leads to lower longer-term rates.
A central bank pursuing yield curve control will announce its target rates and maturities—and that it will buy those securities in whatever amounts are necessary to peg the rate there (i.e., yield curve control would set a spec at that rate). As well as capping longer-term borrowing costs for the government, this will bring down rates for businesses and consumers. The policy also helps convey the message that benchmark short-term rates will be staying low, according to some Fed officials.
Wall Street investors predict that the Fed would most likely select Treasury debt with maturities of somewhere between two and five years as a target. That view aligns with the support expressed by at least a few Fed officials for caps on “short- to medium-term maturities,” according to minutes from their April meeting. It would be a departure from the only other time the Fed used the strategy; during World War II, the central bank capped yields on 30-year bonds as well as Treasury bills.
However, this perceived departure comes mainly because the Fed has established that its primary policy tool is the overnight borrowing rate, and any balance-sheet related policy would have to be conducted in a way that is consistent with its expectations about the path for the overnight rate.
Interest rate pegs theoretically should affect financial conditions and the economy in many of the same ways as traditional monetary policy: lower interest rates on Treasury securities would feed through to lower interest rates on mortgages, car loans, and corporate debt, as well as higher stock prices and a cheaper dollar. All these changes should help encourage spending and investment by businesses and households. Recent research suggests that pinning medium-term rates to a low level once the federal funds rate hits zero would help the economy recover faster after a recession.
If investors believe the Fed will stick to the peg, the Fed could achieve lower interest rates without significantly expanding its balance sheet. In theory, if the commitment to the peg were fully credible, the Fed may not have to purchase any bonds at all.
How Did It Work in Australia and Japan?
In March 2020, the Reserve Bank of Australia (RBA) lowered its official cash rate to the 0.25% lower bound and announced a yield curve control policy. The RBA’s adoption of yield curve control targeted the three-year Australian Government Bonds yield at around 0.25%. The bank will do so by purchasing government bonds in the secondary market. The RBA is targeting only the shorter end of the yield curve. However, the RBA is open to target the longer end of the yield curve, as well as the currency market, if needed.
The success of the policy was acknowledged in a speech by RBA governor Philip Lowe. He noted the yield on three-year government bonds has remained near the targeted 0.25%, having halved since the central bank first intervened. The RBA has explained it intends to continue yield curve control, which reduces borrowing costs by lowering the benchmark three-year government bond rate, until progress is made towards full employment and higher inflation.
The pioneer of yield curve control is the Bank of Japan (BOJ). In January 2016, after years of huge bond purchases failed to fire up inflation and dried up market liquidity, the BOJ cut short-term rates below zero to fend off an unwelcome rise in the yen. The move crushed yields across the curve, outraging financial institutions that saw returns on investment evaporate. To pull long-term rates back above zero, the BOJ shifted from a policy of quantitative easing to one of yield curve control, in which it sought to peg the yield on 10-year Japanese Government Bonds at 0% in an effort to stimulate Japan’s economy. Whenever the market yields on Japanese Government Bonds rise above the target range, the BOJ purchases bonds to push the yield back down. The idea was to control the shape of the yield curve so that short- to medium-term rates—which affect corporate borrowers—fall without pushing down super-long yields too much and reduce returns for pension funds and life insurers.
Yield curve control is an efficient way to cap borrowing costs in a country such as Japan, where the central bank already owns nearly half of the bond market. Having already gobbled up so many bonds, it is hard for the BOJ to commit to buying more at a set pace. Under yield curve control, it only needs to buy as much as needed to achieve its 0% yield target. When yields are stable around the target, the BOJ can taper purchases. At a time when the government is ramping up debt issuance to fund a huge stimulus package, the BOJ can accelerate purchases. By doing so, it can help keep government borrowing costs low and maximize the effect of fiscal spending.
Since the initiation of yield curve control, the BOJ has purchased government bonds at a slower pace and still kept yields on 10-year bonds at historically low levels. So far in 2020, the BOJ is on track to purchase only about six trillion yen in government bonds and has been able to respond to the coronavirus downturn by greatly expanding its purchases of other kinds of assets, including corporate bonds and equities. The BOJ experience demonstrates that credible yield curve control policy can be more sustainable for central banks than a quantity-based asset purchase program.
Will We See it?
Pointing to the recent BOJ experience, advocates of yield curve control believe that the Fed also can achieve lower interest rates with a much smaller balance sheet than it built under quantitative easing. This is because once traders view the central Fed’s promise to keep short-term yields as credible, they will likely stop betting on fluctuations in those maturities, curtailing the need for the central bank to keep buying bonds to anchor yields.
Not everyone is confident that yield curve control will work, however. By committing to keep yields at a certain level, central banks lose control over how much bonds they buy. An opinion piece in Bloomberg has described yield curve control as a “bond trader’s nightmare,” citing lengthy periods in which Japanese Government Bond trading has ground to a halt. Moreover, yield curve control could spur companies to increase their already heavy debt loads, while punishing pension funds and other savers.
If the Fed helps the U.S. government battle the effects of COVID-19 by holding interest rates down, it could find its ability to raise rates after the crisis constrained by the huge budgetary impact of even a small increase in borrowing costs. Still, that could be true regardless of whether the Fed adopts yield curve control—and in any case, that question will not arise until there is a rise in inflation, which most economists do not see as an imminent threat.
Given that the latest rise in yields in early June is driven more by optimism over a recovery rather than excess supply related to ballooning issuance, the Fed will hold off for now. When asked about yield curve control by senators on June 16, Powell said “We’ve made absolutely no decision to go forward on it.”
However, if the initial reopening bounce in activity wanes and the U.S. economy hits one of the many potholes we foresee, this policy option will come up for more active discussion. In short, yield curve control might be a promising tool to support the recovery from the COVID-19 recession, but only if the Fed can achieve a smooth and credible implementation of the policy.
As always, if you have any questions about this article or any financial questions in general, please reach out to Bowen Asset at info@bowenasset.com or (610) 793-1001.
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