What is yield curve control?
Yield curve control is another monetary policy tool from which the Federal Reserve can draw in attempting to guide the economy. They have not chosen to use it yet in the current cycle, but more and more the question is being asked whether it is under consideration.
What is a yield curve? A yield curve is a graphic illustration showing the interest rate on bonds of varying maturities, typically from 3 months out to 30 years. A normal yield curve is upward sloping, reflecting the fact that longer yields are typically higher than shorter yields.
What is yield curve control? Yield curve control is when a central bank identifies a point on the yield curve and pledges to keep rates at a prescribed target. They achieve that goal by vowing to buy enough bonds to ensure rates do not rise above that target level. The Federal Reserve already utilizes other tools to set the rate that banks earn on overnight deposits. Yield curve control can address terms further out such as 1-year rates, 2-year rates, or even up to 10-year rates. Yield curve control is another name for fixing the price of money. You can learn more here.
Has this been tried before? The Federal Reserve employed yield curve control once before, during and after World War II to help the Treasury finance wartime expenditures. Until 1947, under an agreement between the Federal Reserve and the U.S. Treasury, 3-month T-bills and 10-year bonds were capped at 0.5% and 2.5%, respectively. Yield curve control has also been underway in Japan since 2016 when the Japanese central bank targeted 10-year rates at 0% as part of a larger monetary policy effort to fight off the threat of deflation.
Why now? The idea was raised after the U.S. overnight rate was dropped to zero in March, 2020. This was followed by the buffet of liquidity programs which helped unlock financial markets that froze in the face of an economic shut-down. If taking overnight rates to zero doesn’t stimulate the economy enough, targeting lower rates for longer maturities is another way to do even more.
Does it help the economy? In Japan’s case, the answer is no. After nearly five years, they weren’t able to grow their economy or raise the inflation rate enough to meet their goals. In the 1940s, the Fed eventually achieved a growing economy and inflation rate primarily as the result of a peacetime expansion following a decade of depression and a World War. In contrast, we enjoyed a decade-long expansion already under our belts before 2020. We would expect the same outcome from yield curve control as we would if overnight rates were driven below zero; very little.
One thing we have learned over the last decade is that monetary policy ideas that once seemed outlandish no longer are. Economic behavior is fickle and subject to multiple influences, many of which are not impacted by monetary policy. As the economy opens back up in 2021 we expect rates to continue their push higher than began in July, 2020. Unless the Federal Reserve finds comfort with higher rates stemming from an opening economy, it seems likely that we may see them give yield curve control a try once again.