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Yield Curve Control (YCC)

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Yield curve control (“YCC”), also sometimes called interest rate pegs, is where bond yields are set by the central bank.

It is considered a type of unconventional monetary policy. Under yield curve control, a central bank targets an interest rate at a specific maturity.

It buys whatever quantity of government debt securities is needed to hit that.

Yield curve control would require the central bank to announce that it will not allow interest rates across a portion of the curve to rise above a certain rate.

For example, the Fed would announce a rate, say 50 basis points (0.50%), and state that it stands ready to purchase all Treasury bonds of a certain maturity that trade above this level.

A central bank is trying to send the message it is guaranteeing that it will buy as many bonds as it takes to ensure borrowing costs do not rise.

This message makes it easy to communicate to the public and easy for businesses and households to plan around.

Essentially, a YCC policy involves “pegging” or “anchoring” government bond yields at a specific level.

The result is the theoretical ability to control the shape of the yield curve, which is the difference between the yields of short-term bonds and long-term bonds.

A yield curve control policy would allow for greater stability in the level and volatility of interest rates, but might also entail risks such as an excessive increase of a central bank’s balance sheet.

As a monetary policy tool, YCC is an alternative to quantitative easing (QE), which has been used for much of the past decade.

QE (a different type of unconventional monetary policy) uses newly electronically-created money as a broad-brush strategy to buy government bonds and other assets, YCC focuses on explicitly managing specific interest rates with asset purchases and sales.

What is Yield Curve Control?

In normal times, the Federal Reserve System (“Fed”) steers the economy by raising or lowering very short-term interest rates, such as the rate that banks earn on their overnight deposits.

Under yield curve control (“YCC”), the Fed would target a specific interest rate level and stand ready to buy Treasuries to keep the rate from rising above its target.

This would be one way for the Fed to stimulate the economy if bringing short-term rates to zero isn’t enough.

How is YCC different from QE?

Yield curve control is different in one major aspect from QE. QE deals in quantities of bonds, while YCC focuses on the prices of bonds.

For example, the Fed announces that it will buy $1 trillion in Treasury securities.

Buying bonds increase their demand, which increases their price. Because bond prices are inversely related to their yields, the higher price leads to lower interest rates (lower yields).

This is QE.

Under YCC, the central bank commits to buy whatever amount of bonds the market wants to supply at its target price.

In the earlier QE example, the Fed bought $1 trillion worth of securities. In YCC, there is no specific dollar amount being targeted.

It will simply continue to buy until it’s at a price they want.

Once bond markets internalize the central bank’s commitment, the target price becomes the market price.

Why? Because who would want to sell the bond to a private investor for less than they could get by selling to the Fed?

How does YCC work?

Let’s use iPhones as an example.

old iphone

Apple creates a new iPhone with eight cameras. But that’s not all…

The iPhone pays you $10 each year. For two years straight. The price for this iPhone is $1,000.

So you buy it for $1,000 and every year for the next two years, it pays you $10.

The iPhone provides a 1% yield.

$1000 divided by $10 = 0.01 (or 1%).

Let’s say that the Fed wanted the price of the latest iPhone pegged at $1,000. More specifically, they want the YIELD pegged at 1%.

This means that the price of the iPhone must be pegged at $1,000. But people who own them, hate them. Their selfies look horrendous and want to get rid of their iPhones. There’s now too much supply and not enough demand for the iPhone.

The sellers can’t find any buyers at $1,000 so they lower their price and offer $800. But if it’s sold at $800, the yield goes up. It’s now 1.25%. $800 divided by $10 = 0.125 (or 1.25%).

The Fed doesn’t not like this at all! It wants the yield at 1%!

So the Fed steps in and buys up all the iPhones until enough supply is removed, that the price returns to $1,000.

This is YCC Replace the iPhone with a 2-year bond with a 1% yield and now you’re back to the real world.

Has YCC been tried before?

YCC isn’t new.

The Bank of Japan  (“BoJ”) is the only major central bank to have experimented with interest rate pegs in recent history. In 2016, with short-term rates already pushed into negative territory to little effect,  it launched a bold experiment.

The Bank of Japan committed to anchor or peg yields on 10-year Japanese Government Bonds (“JGBs”) at near zero percent. This was done to try and boost persistently low inflation and breathe life into an anemic consumer spending scene.

On days when private investors, for whatever reason, aren’t willing to pay that price, the BoJ purchases more bonds in order to keep yields inside the target price range.

YCC is just one piece of the BoJ’s large policy effort that also includes quantitative easing, forward guidance, and negative interest rates—all aimed at lifting inflation.

The Bank has largely been successful at maintaining that yield of zero percent on JGBs.

Another positive consequence is that YCC has allowed the BoJ to purchase fewer bonds in the last three years than it did under the large quantitative easing program that began in 2013.

Until late 2016, the BoJ was purchasing about 100 trillion yen in JGBs each year. As a result, the BoJ’s balance sheet expanded much faster than that of other major central banks.

Since the initiation of YCC, however, the BoJ has purchased bonds at a slower pace and still kept yields on 10-year bonds at historically low levels.

The BoJ experience demonstrates that a credible YCC policy can be more sustainable for central banks than a quantity-based asset purchase program.

That said,  although YCC has resulted in an effective taper in the pace of JGB buying by the central bank, the ownership breakdown obviously shows that the BoJ has cornered the market.

JGB holders

How does Yield Curve Control affect the economy?

Interest rate pegs theoretically should affect financial conditions and the economy in many of the same ways as traditional monetary policy.

Lower interest rates on Treasury securities should result in:

  • Lower interest rates on mortgages, car loans, and corporate debt
  • Higher real estate prices
  • Higher stock prices
  • Lower dollar

All these changes help encourage spending and investment by consumers and businesses.

Optimal Scenario

Recent research suggests that pinning medium-term rates to a low level once the federal funds rate hits zero would help the economy recover faster after a recession.

But others argue that this transmission from the pegged yield to private-sector interest rates would depend a lot on the Fed’s ability to persuade financial markets that it was really committed to the program.

For example, if the Fed announced it planned to peg yields on 1-year Treasury securities at zero percent.

This means outstanding 1-year notes (which will mature in 1 year or less) are eligible to be bought at an attractive price.

If investors believe the Fed will stick to this program for the full duration of the eligible assets (1 year), then they will begin trading those securities at a price consistent with the peg, because they will be confident in their ability to sell or buy at that price again before the asset matures.

In this scenario, the Fed might have to purchase only a limited number of bonds in order to keep prices at the target, and yields on other private-sector securities would be more likely to fall in line with those on government securities.

If investors believe the Fed will stick to the peg, the Fed could achieve lower interest rates without significantly expanding its balance sheet.

In theory, if the commitment to the peg were fully credible, the Fed may not have to purchase any bonds at all.

Nightmare Scenario

If investors believe the Fed will have to abandon its peg at some point before the year is up, perhaps because they believe the economy will recover and inflation will rise before that time.

Then they would be less willing to buy up 1-year bonds at the Fed’s price, and the Fed would be stuck having to purchase large amounts of the pegged security.

An abrupt spike in yields could force the central bank to purchase Treasuries in large amounts.

In an extreme case, the Fed might have to purchase the entire supply of such securities.

In July 2018, the BoJ was forced to offer to buy unlimited amounts of bonds at 0.11% to prevent long-term rates from rising above target when the 10-year yield was creeping up as global yields rose (due to the Fed raising rates at the time).

Will YCC work in the U.S.?

Although historical examples for YCC involve pegs on long-term rates, policymakers have said that the Fed, if it ever adopted some interest rate peg, would try targeting near or medium-term rates.

This is mainly because the Fed has established that its primary policy tool is the overnight borrowing rate.

This means that any balance-sheet related policy would have to be conducted in a way that is consistent with its expectations about the path for the overnight rate.

Targeting a long-term yield like on the 10-year Treasury would more likely involve a large expansion of the balance sheet.

Sustaining such a strategy would require that investors believe inflation and short-term rates will be low for the duration of the peg.

In the U.S., targeting shorter-term yields would be easier and more likely to be perceived as a credible policy by the public than targeting long-term yields.

Why has a target on 10-year bonds worked in Japan?

One reason is that many private investors in JGBs buy the bonds “buy and hold” rather than trade them.

This means that big institutions who prefer or are required to have a stock of safe government bonds are willing to hold JGBs even if they expect that short-term rates will rise before the bonds mature.

Another reason is BoJ’s huge presence in the JGB market. Years of heavy buying has left them holding almost 50% of the market.

With such an enormous grip on the bond market, this makes YCC a powerful tool for Japan.

In the U.S. though, the government bond market is different. The Treasury market is the largest and most liquid in the world.

Unlike the BoJ, the Fed has a much smaller presence in the U.S. government bond market with holdings of less than 20%.

Investors also frequently buy and sell bonds as they update their expectations about rates.

They would most likely not be “buying and holding” but trading bonds.

What are the risks of Yield Curve Control?

Like other unconventional monetary policies, a major risk associated with YCC policies is that they put the central bank’s credibility on the line.

They require that the central bank commits to keeping interest rates low over some future timeline.

This is exactly what helps encourage spending and investment, but it also means that the central bank runs the risk of letting inflation rise too fast while sticking with its commitment.

For example, If the Fed were to commit to a 3-year peg, they would be betting on the fact that inflation will not run well above its 2 percent target during that period.

If it does, the Fed may have to choose between abandoning its promise about the peg or not holding to its stated inflation objective.

Both would be terrible options in terms of their credibility with the public.

Some of the potential risks associated with QE apply to yield curve control too

For example, both policies might require the Fed to add large amounts of assets to its balance sheet.

Although the Fed’s experience with QE suggests the side effects of this balance sheet expansion are minimal.

The Fed has said that it prefers a smaller balance sheet to a larger one, for multiple reasons.

That said, the YCC program could potentially require a smaller balance sheet expansion than would a QE program.

This is assuming that the peg was credible and it focused on medium-term assets.

This is what makes YCC attractive to policymakers.

Explicitly targeting yields again may also prove politically challenging, renewing concerns about central bank overreach and market intervention.

In summary,  if the central bank can achieve a smooth and credible implementation of a YCC policy, it can be an effective tool to support the economy when traditional monetary policy is constrained by the zero lower bound (ZLB).

ZLB is when the short-term nominal interest rate is at or near zero, causing a liquidity trap and limiting the capacity that the central bank has to stimulate economic growth.

YCC + QE + Forward Guidance

Researchers have suggested that YCC would be more effective if used in combination with forward guidance and QE. 

These two policies are already part of the Fed’s toolkit.

First, forward guidance and a zero-rate peg on near term-securities are mutually reinforcing, because they both tell markets to expect low rates for a while.

Meanwhile, QE could put downward pressure on longer-dated assets than those to which the peg applies.

In other words, when used in combination, the three unconventional monetary policies could simultaneously lower, flatten, and even out the entire yield curve.

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