How yield curve control differs from QE and why the Fed may be waiting
In his post-Federal Open Market Committee meeting press conference, Fed Chair Jerome Powell noted the panel discusses yield curve control in addition to forward guidance and asset purchases.
Many observers expect the Fed to move to yield curve control in September. In doing so, the Fed would cap interest rates for certain maturities — and the belief is it would be mostly shorter-term securities at first — and buy as much as needed to keep yields from rising above the stated top limit.
“I expect YCC to be an active part of the Fed’s toolkit on two fronts,” said Ed Al-Hussainy, senior interest rate and currency analyst at Columbia Threadneedle Investments. First, “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,” and secondly, “as an option to cap long end yields in the event of a disorderly steepening of the Treasury curve.”
Yield curve control is being discussed because “the neutral rate has most likely continued to decline and the Fed is unwilling to use negative Fed funds to chase it.” With the funds rate target not an option, leaving forward guidance and quantitative easing as the most likely Fed tools “for the foreseeable future unless we transition to a high inflation regime,” Al-Hussainy said. Such a transition is “unlikely” in the coming two to three years.
While the Fed has said it discussed yield curve control, Steve Skancke, chief economic advisor at Keel Point, noted, “With interest rates along the yield curve all being low, and within a likely FOMC target range, there is no need to use another FOMC policy tool right now.”
And since the FOMC is pleased with “how well its existing tools were working,” introducing a new tool at this point “would have sparked alarm,” he said. “As it turns out, reinstating its economic forecast of GDP growth and the unemployment rate seems to have triggered enough alarm, along with new coronavirus and unemployment data, for the stock markets to sell off.”
“One way of looking at YCC is that it's a version of quantitative easing — an asset purchase program directed at lowering interest rates at longer maturities while the funds rate target is constrained by the zero lower bound,” said Peter Ireland, an economics professor at Boston College and member of the Shadow Open Market Committee.
Yield curve control differs from QE because with QE the Fed commits “to inject a certain amount of money into the economy by buying bonds, under yield curve control, the Fed commits to seeking to keep bond yields at a pre-determined level, by buying as many bonds as needed whenever necessary to bring yields down to their target,” said Gary Zimmerman, CEO of MaxMyInterest.
If the market believes the Fed will continue yield curve control, “it offers the potential to keep yields lower for longer without necessarily expanding the Fed’s balance sheet significantly, as the mere threat that the Fed will step in to buy bonds at a certain price (and thus, implied yield) could encourage other market participants not to sell bonds at lower prices.”
Proponents say yield curve control might be a better tool than QE, BC’s Ireland said, “because instead of specifying targets for the dollar amount of securities purchased, it would instead specify that purchases will be made as needed to hit targets for interest rates. Since interest rates are what matter for business and household spending decisions, this seems more efficient, because it aims directly at the goal of lowering rates themselves.”
While the Fed used yield curve control during and after World War II “to keep Treasury borrowing costs down to support the war effort,” he said, the goal if they turn to it now “would be to deliver additional monetary stimulus given that the funds rate is in a range near zero.”
In a paper published in American Economic Review in 2014 now Federal Reserve bank of new York President John Williams and economist Eric Swanson and John Williams offer evidence the Fed delivered additional stimulus between 2008 and 2010 by the effects of its policies on one and two-year Treasury rates, he said. “This points to YCC as a potentially effective strategy, that replaces or supports forward guidance by explicitly targeting those one and two-year rates,” according to Ireland. And, should the one- and two-years hit a zero level, yield curve control could be expanded to longer maturities.
Of course yield curve control isn’t perfect. “The main problem, I think, is that by expanding its asset purchases to actually target rates,” Ireland said, “the Fed will be interfering too much in what always have been active private markets and thereby distorting what have always been valuable market signals.”
And the question remains whether it’s even needed at this point. “The two-year rate, for example, is already below 0.25%, because everyone already expects the FOMC to hold the funds rate at zero for the next couple years,” he said. “So YCC seems redundant.”
But if Treasury rates increase, this would be another way for Fed “to do more.” But if the latest employment report is an indication the economy could be “operating pretty close to normal by the end of the year,” raising “a serious question of whether the Fed really does need to do more.”
Lon Erickson, portfolio manager at Thornburg Investment Management, said, “The Fed has plenty of tricks up their sleeve if they need to dazzle the economy some more.”
At his press conference, Powell “beat reporters to the punch” by proactively discussing “potential actions the Fed could take,” he said. While naming forward guidance, asset purchases, and yield curve control, which he said “remains an open question,” Powell notably “didn’t mention negative target rates.”
“I confidently believe the FOMC discussed negative rates again — even though Powell recently declared” negative rates have a “mixed” record of effectiveness, Erickson said. “Here’s what investors should count on in the near term: some form of yield curve control while negative rates remain on the shelf.”
But, again, the question remains is YCC needed. Jack McIntyre, portfolio manager for Brandywine Global, said, “Even if the Fed doesn’t pursue yield curve control, I don’t think yields are going to move significantly higher. We are accumulating a lot of debt, which is inherently deflationary.”
It will also be important to see which maturities the Fed tries to control. “I don’t think they’ll try to control or limit 10-year yields to 50bps. They probably want to do something closer to 1% or 90bps. This will take a lot less firepower in terms of asset purchases to keep yields hovering near that level. There has to be a little bit of credibility to what level they choose to keep rates steady."