Should the Fed engage in yield curve control?

Since the Fed announced its unlimited bond buying program on March 23,¹ we’ve noted that the central bank might eventually need to introduce yield curve control (YCC) at some point to keep the economy going.

We haven’t been alone in that view—many in the market believe the Fed will implement the policy by year end; and indeed, Fed Chair Jerome Powell fanned the flames of that expectation last week when he noted that policymakers were in the early stage of evaluating YCC as a policy option.²

That said, we believe the bar to implementing YCC is getting higher as the economic data comes in stronger than expected, and the Fed’s existing policies are already keeping rates low and stable. We therefore think that the Fed is less likely to take the formal step of implementing this policy by September, which seems to be the consensus view.³ Regardless, buzz around the issue is likely to intensify in the coming months, and here’s a summary of what investors should know about YCC.

YCC has a particularly useful function: It can reduce the amount of Treasuries that the Fed needs to buy to keep yields low. 

As the name of the policy suggests, YCC seeks to create an appropriately steep yield curve by controlling interest-rate levels and reducing its volatility, while simultaneously stimulating economic activity. In practical terms, this requires the Fed to commit to buying as many U.S. Treasuries as needed to keep yields at a predetermined level (usually quite low). In an ideal scenario, this also works through the “expectations channel,” disincentivizing investors from trying to push front-end yields higher, thereby suppressing interest-rate volatility.

YCC also has a particularly useful function: It can reduce the amount of Treasuries that the Fed needs to buy to keep yields low. A commitment from the central bank to anchor rates at a certain level will go a long way to disincentivize investors to bet against it, thereby helping to reduce the size of its bond purchasing program.

It may not be common knowledge, but the Fed has implemented YCC before: It engaged in capping long-term yields in 1942 when supporting the federal government’s need for cheap financing during World War II. However, it took the Fed four years (1947 to 1951) to unwind the policy.⁴ All of this took place before the 1951 Treasury-Fed Accord, in which the Fed gained more independence.

This also isn’t the first time that the Fed has actively considered implementing YCC in recent years—the central bank explored it as a possible option at its October 2010 meeting before QE2 was chosen. At the time, then Fed Chair Janet Yellen said YCC would be “a strategy I would hold in reserve if further stimulus process necessary.”⁵ Indeed.

The biggest question for policymakers embarking on YCC is deciding which part of the yield curve to target. For example, the Bank of Japan introduced YCC in September 2016 and has set a 0.0% target for the 10-year yield. While the Japanese 10-year yield has drifted below the 0.0% target, it’s clear that the policy has been effective at capping upward movements, supporting the widely held view that YCC is substantially better at suppressing yields than raising them.

Ultimately, if the Fed does indeed choose to implement YCC, we think it’s more likely to go down a path that’s similar to the one that the Reserve Bank of Australia took in March—targeting 3-year yield at 0.25%.⁶ In essence, capping the 2- or 3-year yield can be seen as an additional form of forward guidance—it’s an efficient way of letting the market know that rate hikes won’t be taking place during that timeframe, thereby removing uncertainty while simultaneously preventing investors from front-running developments. A different but very similar approach would be to cap yields at a certain maturity (i.e., June 2023)—thereby, theoretically, allowing for a more straightforward exit strategy.

This was discussed at the Fed’s meeting last October before the health crisis unfolded, and the transcript from the meeting noted that “many participants raised concerns about capping long-term rates.”⁷ These include:

• uncertainty regarding the neutral federal funds rate
• the effect of rate-ceiling policies on future interest rates, and uncertainty relating to inflation levels made it difficult to determine the appropriate level of interest rate to target, and when the policy should be removed
• YCC could result in an expansion of the Fed’s balance sheet, and introduce significant volatility to its bond portfolio (both in terms of its size as well as the maturity profile of its holdings)
• managing longer-term interest rates could be construed as “interacting” with the federal debt management process, a potentially sensitive dimension that the Fed is keen to avoid

Beyond concerns highlighted by Fed members, there are also growing arguments against implementing the policy at this juncture: 

• The need to expand monetary policy further is dwindling 
  
  Thanks in part to the Fed’s prompt actions, a credit crisis now seems unlikely. Spreads have tightened significantly since mid-March and quantitative easing appears to have done its job in keeping front-end U.S. rates down, moving within a very tight range—in fact, any investor looking at a chart of the U.S. 2-year yield could reasonably conclude that YCC had already been implemented. 

• YCC isn’t without inherent risk and it’s difficult to unwind
  
  If the market were to price in a sharp rebound in growth and/or inflation, YCC could potentially backfire—optimism about the economy could spark a rotation out of bonds, pushing front-end yields higher. This could force the Fed into making aggressive purchases to maintain its target and lead to an unexpected expansion of its balance sheet. This was highlighted in research published in 2010, noting that “substantial purchases do carry risks that can materialize when the future does not unfold as planned. If incoming data were to show that the recovery is occurring faster than had been anticipated, the Committee may wish to raise its target for the federal funds rate earlier than previously planned.”⁸ While we expect U.S. interest rates to be on hold for the next five years, we can foresee a scenario where the Fed will need to raise rates earlier than expected, and YCC would complicate that environment considerably.
  
  
• If rates are rising for good reasons
  
  Artificially suppressing rates as the economy recovers could be seen as a policy mistake. In our view, this represents a real risk to the Fed given the unprecedented amount of uncertainty that COVID-19 has produced. The probability of both upside and downside surprises remains significant. That said, should rates start to rise due to liquidity issues, a case for the immediate implementation of YCC could be built. However, that’s not where we are now.
  
  
• The Fed already owns a significant chunk of the Treasury market
  
  Consider this: The Fed expanded its balance sheet more in the past three months than it did in the entire six years between December 2007 to November 2013. In fact, as of mid-June, it owns 16% of all outstanding Treasuries³—in our view, it certainly makes sense for the Fed to explore other options before turning to YCC.
   

"While we expect U.S. interest rates to be on hold for the next five years, we can foresee a scenario where the Fed will need to raise rates earlier than expected, and YCC would complicate that environment considerably."

• The Fed has other tools in its tool kit
  
  In the near term, the Fed can turn to tools that are less difficult to unwind and carry fewer risks, for instance, refining forward guidance. Our sense is that the Fed is deliberately staying away from providing more specific forward guidance beyond what it said on June 10—a vague statement noting that “the Committee expects to maintain this target range until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”⁹ By waiting, the Fed is possibly setting aside some dry powder for when the economy needs it most. Another option could entail making explicit changes to the Fed’s inflation targeting regime as it completes its inflation framework review this summer. By stating something to the effect that the Fed will create a meaningful “overshoot” of 2% inflation, it can also keep short-term rates low. We suspect both these adjustments would be made before YCC would be seriously considered.
  
  
• Verbal intervention
  
  The threat of YCC may well be as powerful as its application. Consistently reminding investors that YCC is on the table is likely to keep the market from pushing rates much higher. In our view, this approach will likely work for now, but prolonged empty talk could also mean that the market might not get the additional boost when the actual announcement arrives. 

At this juncture, it’s unclear whether the Fed will ultimately implement YCC. While the central bank has said that it’ll examine the policy, senior Fed officials have voiced their doubts about its viability. Mounting pressure for the Fed to implement policies that can directly benefit Main Street might also alter the course of policy discussions. That said, even if the Fed’s enthusiasm about YCC had waned, the central bank isn’t likely to draw attention to it. However, we think near-term improvements in economic data should push the market to fade its belief that YCC is a lock-in.

1 “Federal Reserve announces extensive new measures to support the economy,” federalreserve.gov, March 23, 2020. 2 “Powell reiterates uncertain path, timing of U.S. economic recovery,” BNNBloomberg.ca, June 16, 2020. 3 Bloomberg, June 16, 2020. 4 “The Fed’s Yield-Curve-Control Policy,” Federal Reserve Bank of Cleveland, November 29, 2016. 5 “Transcript: October 15 Conference Call, 2010,” federalreserve.gov, October 15, 2010. 6 “3-Year Australian Government Bond Yield Target,” Reserve Bank of Australia, March 19, 2020. 7 “Minutes of the Federal Open Market Committee,” federalreserve.gov, October 2019. 8 “Strategies for Targeting Interest Rates Out the Yield Curve,” federalreserve.gov, October 13, 2010. 9 “Federal Reserve Issues FOMC Statement,” June 10, 2020. 10 “Fed’s Kaplan says he’s skeptical of yield-curve control,” marketwatch.com, June 15, 2020.