Fed Not Ready To Roll On Yield-Curve Control

Just about the only thing anyone was interested in from the June Fed minutes was incremental color around the yield-curve control (YCC) discussion.

At the June meeting, the Fed put a floor under asset purchases, and delivered a new set of dots, which of course showed rates on hold likely through 2022.

Jerome Powell’s assessment of the outlook (as communicated during the presser) was generally seen as being a shade on the downbeat side, at least if you’re the White House, where a certain armchair rates strategist was looking for a bit more optimism out of a Fed chair who has done everything under the sun to pacify the president and markets, both of whom are perpetually petulant.

Relive the June FOMC: Fed Puts A Floor Under Asset Purchases, Sees Rates At Zero Through 2022

Fast forward a few weeks and the data has been ok, all things considered. Fed officials have hewed closely to a script centered around the absolute necessity of ensuring the economy doesn’t suffer structural damage.

Part of that messaging revolves around prodding lawmakers into more fiscal stimulus without explicitly presuming to instruct Congress on what needs to be done. (That job is left to Steve Mnuchin.)

When it comes to what else the Fed can do, YCC is next up, and a (slim) majority of analysts and economists see the US adopting some form of the policy in September or, at the latest, in the fourth quarter.

Officials have continually alluded to briefings and studies around YCC and the minutes offer the following (possibly) useful color in that regard:

The second staff briefing reviewed the yield caps or targets (YCT) policies that the Federal Reserve followed during and after World War II and that the Bank of Japan and the Reserve Bank of Australia are currently employing. These three experiences illustrated different types of YCT policies: During World War II, the Federal Reserve capped yields across the curve to keep Treasury borrowing costs low and stable; since 2016, the Bank of Japan has targeted the 10-year yield to continue to provide accommodation while limiting the potential for an excessive flattening of the yield curve; and, since March 2020, the Reserve Bank of Australia has targeted the three-year yield, a target that is intended to reinforce the bank’s forward guidance for its policy rate and to influence funding rates across much of the Australian economy. The staff noted that these three experiences suggested that credible YCT policies can control government bond yields, pass through to private rates, and, in the absence of exit considerations, may not require large central bank purchases of government debt. But the staff also highlighted the potential for YCT policies to require the central bank to purchase very sizable amounts of government debt under certain circumstances–a potential that was realized in the U.S. experience in the 1940s–and the possibility that, under YCT policies, monetary policy goals might come in conflict with public debt management goals, which could pose risks to the independence of the central bank. 

There are actually a few notables there, starting with the notion that central banks can, of course, control bond yields.

Although this isn’t a popular way to characterize the situation, the fact is, bond yields are a policy variable. I’ve repeated that on a number of occasions recently and it doesn’t go over well with some readers, especially those inclined to be nostalgic for the days of the “bond vigilantes”.

Be that as it may, the visual in the top pane (figure) speaks volumes.

Australia (which adopted a version of YCC in March) has met with some success.

Note also the allusion in the passage from the minutes to YCC allowing for the central bank to actually purchase less in the way of government debt. Japan’s “stealth taper” is an example of that dynamic. The figure below is just a zoomed-in version of the visual in the top pane above, with some annotations from Morgan for clarity (it’s a bit dated, but I like it because it drives home the point).

There’s been more than a little evidence over the past several sessions to suggest the market is starting to price YCC in. Five-year yields hit a record low Tuesday, for example, and OI in five- and 10-year futures is up.

For those interested, here’s a quick rundown of what Fed officials have said over the past month (or two) 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

Risk asset bulls are excited about the prospect. 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 (more here).

But, even if markets are ready, the Fed is not. Or at least they weren’t as of a few weeks ago, and are unlikely much further down the road now.

“In their discussion of the foreign and historical experience with YCT policies and the potential role for such policies in the United States, nearly all participants indicated that they had many questions regarding the costs and benefits of such an approach”, the minutes read. Below is the additional relevant color:

Among the three episodes discussed in the staff presentation, participants generally saw the Australian experience as most relevant for current circumstances in the United States. Nonetheless, many participants remarked that, as long as the Committee’s forward guidance remained credible on its own, it was not clear that there would be a need for the Committee to reinforce its forward guidance with the adoption of a YCT policy. In addition, participants raised a number of concerns related to the implementation of YCT policies, including how to maintain control of the size and composition of the Federal Reserve’s balance sheet, particularly as the time to exit from such policies nears; how to combine YCT policies–which at least in the Australian case incorporate aspects of date-based forward guidance–with the types of outcome-based forward guidance that many participants favored; how to mitigate the risks that YCT policies pose to central bank independence; and how to assess the effects of these policies on financial market functioning and the size and composition of private-sector balance sheets. A number of participants commented on additional challenges associated with YCT policies focused on the longer portion of the yield curve, including how these policies might interact with large-scale asset purchase programs and the extent of additional accommodation they would provide in the current environment of very low interest rates. Some of these participants also noted that longer-term yields are importantly influenced by factors such as longer-run inflation expectations and the longer-run neutral real interest rate and that changes in these factors or difficulties in estimating them could result in the central bank inadvertently setting yield caps or targets at inappropriate levels.

The bottom line is that the Fed isn’t near ready to go yet when it coms to targeting the curve, and although I suppose that may have implications for some trades put on over the past week or two, I’d be surprised if the commentary from the minutes is “news” to the folks who are actively trading the eventual implementation of the policy.

For now, the Fed clearly prefers to lean on forward guidance, even as officials are coming around to the possibility that YCC in some form can reinforce that, if it becomes apparent the market isn’t “listening”.

Other than that, a word search for “uncertain” turns up 45 hits in the June minutes. That pretty much sums it up when it comes to how the Fed is thinking about the outlook.

Full minutes