During last week’s Federal Open Market Committee (FOMC) press conference, Federal Reserve (Fed) Chair Powell promised to deploy “our full range of tools to support the economy in this challenging time.” The Fed’s tool kit has been expanding rapidly since the outbreak of COVID-19 to include new measures of stimulus designed to ease the economic hardship impacting so many Americans. Another significant Fed policy response under consideration is yield curve control (YCC). Although this is not a new tool for the Fed, it has been used only once before — when the United States was fighting a different enemy during World War II.
YCC moves beyond the Fed’s current bond purchase programs or quantitative easing to establish specific interest rate caps on intermediate or long-term Treasuries. YCC policies were implemented by the Bank of Japan in 2016 and the Reserve Bank of Australia following the coronavirus outbreak this year. The Reserve Bank of Australia has a 25 basis-point yield target for three-year government bonds while the Bank of Japan’s YCC policy targets a 10-year yield at zero. The amount of government bonds purchased by the Fed to keep rates capped will vary based on the level of private demand for Treasury issuance.
The most obvious benefit of YCC is keeping borrowing costs low to encourage spending and investment. YCC will also help maintain an upward-sloping yield curve, which supports bank lending activity and market functioning. Finally, YCC would reduce the need for negative interest rates in the United States — a policy with limited success to date in Europe and Japan.
Critics of YCC warn the absence of market-driven interest rate pricing will deprive investors and policymakers of valuable information about the path of economic growth and inflation. Interest rate caps will not only distort the pricing of Treasury bonds but enable money-losing companies to remain alive with easy credit — a trend already on the rise since the great financial crisis. Exiting YCC policy could also prove challenging for the Fed, as it was following the end of World War II when rates stayed low despite a significant uptick in inflation.
Treasury bond pricing has needed little additional support since the Fed promised in late March to keep buying “in the amounts needed” to support the economy and maintain financial stability. Despite a brief rise toward the 1% level after the unexpectedly strong May employment report, 10-year Treasury rates made a quick return to the middle of the recent trading range near 70 basis points. The FOMC’s forward guidance suggesting short-term rates will remain at zero until the end of 2022 and its promise to maintain the pace of bond purchase activity are likely to keep interest rates in check. However, YCC is an increasingly viable tool for Fed policymakers who are committed to doing “whatever it takes.”