When it comes to yield-curve control (YCC), Fed officials have been keen to emphasize that more “study” is necessary before adoption/implementation in the US.
That’s been the message since before the June meeting, and will likely continue to be the message for at least the next several weeks.
But, YCC is coming — almost surely. That is the “logical” (or illogical, depending on how you want to look at it) next phase in the evolution of US monetary policy in an era where the country is borrowing to fund trillions in virus relief and, hopefully, additional stimulus including badly-needed infrastructure spending.
For those interested, here’s a quick rundown of what Fed officials have said recently about YCC:
- Loretta Mester: I’m open to using it as a reinforcement to forward guidance, but I’d like to see more study of that. I haven’t come to a conclusion one way or the other yet on whether the benefits of it exceed the costs
- Jerome Powell: We’re at the early stages of evaluating yield-curve control
- Robert Kaplan: Right now I’m in the stage — for me — of having a little skepticism but wanting to continue to explore it
- Jim Bullard: On yield-curve control, this is certainly something the committee could consider, going forward. I doubt that it would be real impactful at this stage because rates are low and expected to stay low
- John Williams: Yield-curve control, which has now been used in a few other countries, is I think a tool that can complement -– potentially complement –- forward guidance and our other policy actions. So this is something that obviously we’re thinking very hard about. We’re analyzing not only what’s happened in other countries but also how that may work in the United States
- Richard Clarida: Yield-curve control is a natural compliment to guidance
So, what would it means for equities if the Fed were to target levels in some section of the curve in order to reinforce forward guidance?
Well, BofA’s Michael Hartnett notes that equity bulls are fond of pointing to historical precedent.
“The Fed announced yield-curve control in March 1942, capp[ing] yields at 2.5% to allow Treasury to fund cheap debt in WWII — the policy ended March 1951”, he writes, in a note dated Thursday, adding that while it’s “impossible to isolate the impact, bulls note YCC coincided with [the] start of [a] strong rally in US stocks, multiple expansion [and an] inflection point up in US home prices”.
Generally speaking, the Fed is seen adopting some version of YCC in September, although that is far from a sure bet.
In the 40s, the multiple expansion that played out alongside the policy was notable, to say the least. Trailing PEs rose from 8x to 14x in the space of two years.
For those unfamiliar, below is a brief historical account from The New York Fed. There are many such short histories, and I’ve embedded another from the Cleveland Fed as well.
Via The New York Fed
The coronavirus pandemic has prompted the Federal Reserve to pledge to purchase Treasury securities and agency mortgage-backed securities in the amount needed to support the smooth market functioning and effective transmission of monetary policy to the economy. But some market participants have questioned whether something more might not be required, including possibly some form of direct yield curve control. In the first half of the 1940s the Federal Open Market Committee (FOMC) sought to manage the level and shape of the Treasury yield curve. In this post, we examine what can be learned from the FOMC’s efforts of seventy-five years ago.
Lessons in Yield Management
The FOMC’s efforts offer two lessons in yield curve management:
1. The shape of the yield curve cannot be fixed independently of the volatility of interest rates and debt management policies.
During World War II the FOMC sought to maintain a fixed, positively sloped curve. The policy left long-term bonds with the risk characteristics of short-term debt but a yield more than 200 basis points higher. At the same time, the Treasury pursued a policy of issuing across the curve, from 13-week bills to 25-year bonds. Faced with investor preferences for the higher yielding, but hardly riskier, bonds, the System Open Market Account had to absorb a substantial quantity of bills. A flatter curve and/or a less rigid interest rate policy might have required less aggressive interventions.
2. Large-scale open market operations may be required in the course of refixing, from time to time, the shape of the yield curve.
After 1946, Federal Reserve officials pursued a program of gradual relaxation of the wartime regime, beginning with the elimination of the fixed rate for 13-week bills, continuing with incremental increases in the ceiling rate on 1-year securities, and then moving further out the curve, with the ultimate goal of a free market for all Treasury debt. Following the elimination of the fixed bill rate in 1947, investors began to move their portfolios into shorter-term debt. The result was a massive shift in the composition of the Open Market Account as the Account bought bonds and sold bills to accommodate the changing maturity preferences of private investors.
The Coming of War
World War II began on Friday, September 1, 1939. By mid-1940, Germany had defeated Poland, France, and Belgium, and a British expeditionary force had been forced to withdraw from the continent. In a speech on October 30, President Roosevelt promised Britain “every assistance short of war” and Britain soon began placing orders for large quantities of planes, artillery, tanks, and other heavy weapons, even though it lacked the financial resources to pay. Congress signaled that it would finance whatever Britain required when it passed the Lend-Lease Act in March 1941.
Emanuel Goldenweiser, director of the Division of Research and Statistics at the Federal Reserve Board, recommended to the FOMC in June 1941 that “a definite rate be established for long-term Treasury offerings, with the understanding that it is the policy of the Government not to advance this rate during the emergency.” He suggested 2½ percent and argued that “when the public is assured that the rate will not rise, prospective investors will realize that there is nothing to gain by waiting, and a flow into Government securities of funds that have been and will become available for investment may be confidently expected.” Three months later, Goldenweiser recommended a congruent monetary policy, “a policy under which a pattern of interest rates would be agreed upon from time to time and the System would be pledged to support that pattern for a definite period.”
Financing American Participation in World War II
Active U.S. participation in World War II followed the bombing of Pearl Harbor in December 1941 and ended with the surrender of Germany in April 1945 and Japan four months later. From year-end 1941 to year-end 1945, Treasury indebtedness increased from $58 billion to $276 billion. Marketable debt accounted for 72 percent of the increase; war savings bonds and special issues to government trust funds accounted for the balance. The increase in marketable debt included $15 billion of bills, $38 billion of short-term certificates, $17 billion of notes, and $87 billion of conventional bonds.
By mid-1942 the Treasury yield curve was fixed for the duration of the war, anchored at the front end with a ⅜ percent bill rate and at the long end with a 2½ percent long-bond rate. Intermediate yields included ⅞ percent on 1-year issues, 2 percent on 10-year issues, and 2¼ percent on 16-year issues.
Experience with the Fixed Pattern of Rates
Fixing the level of Treasury yields endogenized the size of the System Open Market Account: the Fed had to buy whatever private investors did not want to hold at the fixed rates. As a result, the size of the Account increased from $2.25 billion at the end of 1941 to $24.26 billion at the end of 1945.
Fixing the pattern of Treasury yields endogenized the maturity distribution of publicly held debt. In each market sector, the Fed had to buy whatever private investors did not want to hold and, up to the limits of its holdings, had to sell whatever private investors wanted to buy beyond what the Treasury was issuing.
Investors quickly came to appreciate that they faced a positively sloped yield curve in a market where yields were at or near their ceiling levels. An investor could move out the curve to pick up coupon income without taking on more risk and then ride the position down the curve, adding to total return. This strategy of “playing the pattern of rates” led investors to prefer bonds to bills. Their preferences, coupled with the Treasury’s decision to issue in all maturity sectors, forced the Open Market Account to buy unwanted bills and to sell the more attractive bonds. By late 1945 the Account held 75 percent of outstanding bills, but—in spite of heavy bond issuance by the Treasury—fewer bonds than it had held in late 1941.
The essential problem was that the positive slope of the curve was inconsistent with the negligible volatility of rates and the Treasury’s issuance program. In early 1949, Allan Sproul, the president of the Federal Reserve Bank of New York, concluded that “in a supported market in which all obligations might be regarded as demand obligations, a horizontal rate structure would theoretically be required.”
Following the cessation of hostilities in August 1945, the overarching objective of Federal Reserve officials was regaining control of open market operations. A “cold turkey” approach, abruptly terminating support for the fixed pattern of rates, was never seriously considered. Instead, officials pursued a more measured approach, first terminating the ⅜ percent fixed bill rate, then gradually lifting the caps on yields on coupon-bearing securities, starting with 1-year instruments.
The FOMC terminated the ⅜ percent bill rate on July 3, 1947. Bill yields increased to 66 basis points in July, 75 basis points in August, and 95 basis points by the end of the year. Investors had little incentive to buy 1-year securities at ⅞ percent when bill yields were rising so dramatically and the Treasury was forced to reprice its fall 1-year offerings to 1 percent, and its December offering to 1⅛ percent.
Rising bill rates triggered a reversal of the preference for bonds over bills. In the face of steady selling, bond yields rose from 2.22 percent in June 1947 to 2.39 percent in December and then to 2.45 percent a month later. The Fed sought to cushion the reversal by buying bonds and selling (or running off) bills. In the second half of 1947, the Open Market Account bought $2 billion of bonds while selling or running off $3 billion of bills. In 1948, the Account bought an additional $8 billion of bonds and reduced its bill position by $6 billion.
In late November 1950, facing the prospect of another major war, the Fed, for the first time, sought to free itself from its commitment to keep long-term Treasury yields below 2½ percent. At the same time, Secretary of the Treasury John Snyder and President Truman sought a reaffirmation of the Fed’s commitment to the 2½ percent ceiling.
The impasse continued until mid-February 1951, when Snyder went into the hospital and left Assistant Secretary William McChesney Martin to negotiate what has become known as the “Treasury-Federal Reserve Accord.” Alan Meltzer has observed that the Accord “ended ten years of inflexible [interest] rates” and was “a major achievement for the country.”
- A more detailed version of this post, with footnotes, appears in Federal Reserve Bank of New York Staff Report no. 913, February 2020.
- Garbade, Kenneth D. 2012. Birth of a Market: The U.S. Treasury Securities Market from the Great War to the Great Depression, MIT Press, pp. 338-48.
- Meltzer, Allan. A History of the Federal Reserve, Volume 1: 1913-1961, University of Chicago Press (2003), chapter 7