Count on the Fed to Take Control of the Yield Curve

(Bloomberg Opinion) -- Given the proximity to the effective lower bound for interest rates, the Federal Reserve is looking to bolster its policy arsenal ahead of the next recession. Watch for the “bond traders’ nightmare” of adding yield curve control to the Fed’s toolkit to rise to the top of the list as the policy review draws closer to an end.

Policy makers reviewed their options at the October Federal Open Market Committee meeting as part of their ongoing strategic assessment. The discussion turned to possibility of capping yields on U.S. Treasuries as a way to support the economy. While some participants believed that keeping long-term Treasury yields from rising would be an attractive option, the majority focused on the idea of controlling short- to medium-term interest rates.

Fed Governor Lael Brainard subsequently fleshed out the case for yield curve control at the short and medium horizons to create additional accommodation after the main overnight policy rate fell to zero. In practice, after the Fed had reached the zero-lower bound for policy it would provide additional accommodation if needed by capping interest rates at progressively longer portions of the yield curve.

Forward guidance would enhance the credibility of the caps. For example, the Fed commits to holding the policy rate at zero until the economy reaches full employment and inflation stays at its 2% target for a year. The Fed forecasts the time to reach these objectives and then caps Treasury yields out to that horizon. Presumably, the combination of forward guidance and caps would be sufficiently credible to allow the Fed to reduce actual large-scale asset purchases, thus limiting an expansion in its balance sheet. 

Bloomberg Opinion columnist Brian Chappatta worries about the ripple effects on bond market:

Certainly there’d be less need for U.S. rates traders or strategists (imagine the research: yields will be little changed!). What would a period of strict yield-curve control mean for the bond markets when the Fed achieves its dual mandate? Would that create massive volatility in Treasuries and corporate debt when the caps are lifted? And what if inflation never reaches the central bank’s target? Are pension funds and other savers expected to survive near the effective lower bound indefinitely? Is the Fed fine with companies continuing to load up on cheap debt?

Under yield curve control, short to medium rates would change only minimally (the Fed might use a band of, say, zero to 25 basis points rather than a precise target). I have written my share of “the Fed is holding steady at zero” articles to recognize the implications for traders and strategists. Still, the same would be true under credible forward guidance. Moreover, if economic conditions changed, the Fed would increase or decrease the expected time at the zero bound and adjust the caps accordingly. This would create trading activity at the boundary of the caps and beyond.

The Fed would unwind the program smoothly by ending the caps continuously in reverse, minimizing volatility in bond markets when the Fed reaches its objectives. Brainard argues that this would limit the risk of another “taper tantrum” such as the rise in long-term rates that occurred after former Fed Chairman Ben Bernanke hinted in 2013 that the central bank would begin tapering the size of its bond purchases.

Regarding Chappatta’s final questions, I think market participants best prepare for the possibility - if not likelihood - that a very persistent period of near-zero rates is exactly where we are heading regardless of the exact tools the Fed uses to get us there. If Japan is, as it seems, not an outlier and the U.S. follows a similar path, then longer-term rates still have room to fall. This is the world we now live in until inflationary pressures start to take hold.

To be sure, these are preliminary discussions. The final outcome of the Fed’s policy review may not explicitly endorse yield curve control. But the discussion still reinforces the Fed’s direction – monetary policy in the next recession will move toward lower for longer much more quickly. It will make the Fed’s response to the last recession look hawkish in comparison.

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.

©2019 Bloomberg L.P.