Yield-Curve Control Could Complicate Fed’s Exit Strategy

(Bloomberg Opinion) -- Federal Reserve Chair Jerome Powell has said that he and his colleagues are “not even thinking about thinking about raising rates.” That doesn’t mean we can’t still speculate about what the central bank’s exit from ultra-accommodative policy will look like, however many years into the future that may be.

Effectively, by announcing a monthly floor on purchases of U.S. Treasuries and agency mortgage-backed securities last week, the Fed started what will surely be a long countdown to a second “taper tantrum.” The original episode happened in 2013, when yields lurched higher after Ben S. Bernanke surprised investors by suggesting that the central bank would soon scale back its bond-buying program. In general, the Fed has indicated that interest rates are its primary tool and asset purchases are a more “extraordinary” measure, even if they seem commonplace by now. That means before Powell would think about increasing rates, he’d look to steady the balance sheet.

Such a move is probably “some years away,” Powell said during testimony to the Senate Banking Committee on Tuesday, though “that’s probably the way we’d start” to tighten policy. He explained what the process would look like:

“It’s just something that has to be taken very carefully and very slowly and it’s not something we’re thinking about now. ... When the time comes, what we did from 2014 to 2017, we just froze the size of the balance sheet, and as the economy grows, the balance sheet shrinks as a percent of the economy. So that’s a very passive way, and that didn’t cause any reaction in the market. I think there have been market reactions when we actually try to shrink the size of the balance sheet.”

Powell conveniently started his flashback in 2014, skipping over the market’s tantrum over the Fed just reducing the pace of its bond purchases. Later in his testimony, he again referred to 2014 through 2017 as “a very peaceful period.” Getting to that point wasn’t without fits and starts.

It might be worse this time around — or, at least, weirder. The Fed is considering whether to undertake yield-curve control to reinforce its forward guidance and tame shorter-term borrowing costs. The implicit threat behind the policy is that the central bank will gobble up as many Treasuries as necessary to fix yields at or below a set level. Most economists have said they expect the Fed to roll out yield-curve control later this year, even though that doesn’t seem pressing as long as bond traders are behaving on their own.

Figuring out how the Fed would ever manage to untangle itself from a mix of yield-curve control, asset purchases and near-zero interest rates is a challenge. “I suspect that part of the reason the Fed wants to discuss this some more is that they need to figure out how exactly to get out,” said Gennadiy Goldberg, senior U.S. rates strategist at TD Securities. “The Fed doesn’t want to enter a program it doesn’t have a good idea how to wind down.”

Goldberg says he expects yield-curve control will happen later this year to prevent traders from pulling forward expectations for interest-rate increases when the economy rebounds from its lockdown lows. Meanwhile, the Fed will likely keep buying bonds through at least the end of 2021. “Anchoring the front end would help prevent any tantrum reaction of markets expecting that a paring of QE at some future point would lead to rate hikes right away,” he said.

This combination of policies can become circular in a hurry, however. The only way to scale back would seem to hinge upon bond traders collectively not challenging the central bank on its yield caps.

Currently, the median expectation among Fed officials is that interest rates will remain near zero through at least the end of 2022. If they wanted to hammer home that outlook, they could announce a cap on two- or three-year Treasury yields. The Fed could end up purchasing hundreds of billions of dollars of the maturities, or virtually none. The Bank of Japan precedent, Goldberg says, suggests traders would initially test the Fed’s resolve but eventually back down. Either way, it’s a tricky environment to formally scale back bond buying. 

The Fed has some flexibility. Citigroup Inc. strategists Jabaz Mathai and Jason Williams recently described how they see yield-curve control working:

“The Fed would announce on the implementation date – let’s call it Sep 16, 2020 that it stands ready to buy any Treasury security that matures on Sep 16, 2023 or earlier at a yield of say, 25bp. As time passes, the Sep 16, 2023 terminal date would not change (unless explicitly extended); thus, the maturities of the securities the Fed is committed to buy would decline over time, and the program would automatically end on the specified terminal date. Moreover, any securities that the Fed bought under the program would mature by the terminal date, leaving no lasting effect on the Fed’s balance sheet. This ‘automatic exit’ is an attractive aspect of the approach.”

It’s still hard to see how the Fed averts any market tantrum. If the terminal date doesn’t change from meeting to meeting, that itself is a new form of policy action, implying tapering and setting a date at which interest-rate increases are back on the table. How far in advance would officials deem it necessary to push back the end of yield-curve control? How accurate are their forecasts for the U.S. economy? All the while, the Fed would presumably still be buying longer-term Treasuries — would that also taper off near the stated terminal date?

I’m not the only one with concerns. Dallas Fed President Robert Kaplan said on Monday that he would not rule out yield-curve control, but he’s skeptical and fears it could distort the pricing mechanism in the Treasury market. “I think it’d be wise to show some restraint and to assess the implications of what we’ve done so far before we make our next move,” he said.

On Tuesday, in what seemed to be a nod to this viewpoint, Powell said of yield-curve control: “We’ve made absolutely no decision to go forward on it. As you’ve seen, some of my colleagues have given speeches lately raising questions about it. So it’s not a decision that we’ve made. The sense of it is if rates were to move up a lot for whatever reason and we wanted to keep them low to keep monetary policy accommodative, we might use it.”

Given the potential headaches around entering and exiting the policy, the Fed should use discussions of curve control to jawbone traders for as long as possible. Three-year Treasuries already yield less than 0.25%, and in the past two months they’ve topped out at 0.31%. Perhaps the “dot plot” and broad bond buying are enough to tame the Treasury market. It would certainly be more straightforward to unwind, whenever central bankers start “thinking about thinking about” that.

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

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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