Yield Curve Control
Yield Curve Control Vs. Quantitative Easing
In addition to the monetary toolbox of QE and Forward Guidance, Yield Curve Control is a mechanism that involves pegging long-term interest rates and where bond yields are set by central banks. Banks steer the economy by altering short- term interest rates, such as the rate the banks earn on their overnight deposits during normal times. However, under YCC central bank’s target the long-term interest rates and pledges to keep the rate rising above its target. Under YCC, the custodian of reserves, focuses on bond pricing whereas under the traditional Quantitative Easing programs central banks tend to focus on bond-buying, for instance the $1 Trillion the Fed has bought in Treasury Securities.
Therefore, to successfully execute a Yield Curve Control program, Central Banks have to commit to buy whatever amount of bonds the market wants to supply at its target price. Once the bond market internalizes the central bank’s commitment, then the target price becomes the market price. This essentially means that if financial markets believe in the central bank’s promise to continue the YCC program in the long run, then markets offer to keep yields lower for longer without necessarily expanding balance sheets. Since interest rates are what matter for businesses and households spending decisions, YCC seems to be more efficient than Quantitative Easing because instead of specifying targets for the dollar amount of securities purchased, it specifies the purchases that will be made to hit targets for interest rates.
Has this technique been used before?
Japan’s economy has been subject to a long-lasting deflation problem. With inflation rates below 2% even after (QQE) Quantitative and Qualitative Easing programs and (NIRP) Negative Interest Rate Policies, in September 2016 the Bank of Japan introduced QQE with YCC – with an aim to issues created by QQE with NIRP, and target inflation at 2%. This essential ensures a degree of upward slope in the yield curve since its overnight policy rate is negative. The only precedent to the Bank of Japan was the Fed’s use of the YCC technique during World War II. With growing concerns over US Budget deficit and inflation put upward pressures on long-term interest rates. The Fed capped the long-term interest rates at 2.5% a
(YCC) and Treasury Bills at 0.325% (QE) in an attempt to stabilize the bond market. This operation effectively helped the US government monetize its war efforts.
Presently, as of March 2020, The Reserve Bank of Australia has adopted the YCC technique in response to the coronavirus. They have targeted three- year bonds at 0.25% coupled with its Quantitative Easing program. The success of the program was recognized by Philip Lowe -RBA Governor, when he noted that the yield on the three-year government bond remains near the targeted 0.25%, having halved since the central bank first intervened a month ago. This program towards reducing borrowing costs until progress is made in achieving full employment and higher inflation levels. Even India to a certain extent has been using a form of yield curve control since February.
The Chief Economist at the ECB, Philip Lane, however; stated that they are not going to consider adopting Yield Curve Control. He argued that only the only way to ensure yields is to promise to buy everything, at least at the maturity being targeted. Since the Eurozone has 19 governments (2 more on the way) with each of them having huge variations in economic policies and budgetary strength, it will be difficult to implement and successfully execute the Yield Curve Control policy.
What about the Fed?
The fed has played its role in bolstering economic activity and keeping hopes of a V-Shaped recovery through a multitude and series of monetary policies. The central reserve has already reduced short-term interest rates to hover around 0% until 2022 and has effectively deployed its Quantitative Easing and Forward Guidance tools which have been used during the 2008 crisis and the Great Depression. With short term interest rates at their Zero Lower Bound, the Fed and the Federal of Open Market Committee (FOMC) is now considering Yield Curve Control (YCC) as a way to cement forward guidance on the front end of the curve and provide the treasury an incentive to skew issuance towards bills/short-term notes in funding the 2020-21 deficits. According to Ed Al-Hussainy a senior interest rate and currency analyst at Columbia Threadneedle Investments, YCC provides an option to cap long-term yields in the event of a disorderly steepening of the yield curve.
Now the way I see it, if done right, it would give the fed a way to keep financial conditions loose, even in an environment in which investors began to anticipate tighter monetary policy. Furthermore, the risk associated with YCC is limited. The program allows the Fed to hold to maturity any securities it purchased as long as they don’t book any capital losses.
However, the Fed should consider the potential downside of implementing such a program. Firstly, the approach of capping yields by the Bank of Japan, has not yet proved to be successful on the inflation front and hence this policy may not work. Secondly, targeting the yield curve could potentially “come in conflict with public debt management goals, which could pose risks to independence of the central bank”. And lastly, the continuous stimulus programs and bond buy-back schemes, long-term financial stability is in danger. An open-ended program of buying long- term treasury debt will have a knock-on effect on the value of the US Dollar due to a rising budget deficit. In turn, this would limit the appeal of Dollar denominated assets to overseas investors.
Instead of taking on huge risks, the Fed should continue to hold the overnight interest rates at zero until the inflation is high as 2% and the labor market has returned to full employment. Along with holding short-term interest rates, the Fed should purchase longer-term securities and not communicate some ironclad commitments until the dual-mandate benchmarks are achieved. I believe this is a better way for the Fed to effectively use its balance sheet capacity given the economic situation.
By Aman Advani - University of Warwick
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