The Federal Reserve has set a cracking pace in terms of supporting the US economy and global financial system. But what if it needs to do more?
Policymakers have winced at the idea of negative interest rates. But exerting a stronger grip over the US government bond market is one potential option.
Capping the level of Treasury yields, also known as yield curve control, would repeat a policy the Fed last used during and after the second world war. To some extent, the market is already behaving as if it has happened. The five-year Treasury yield has flatlined below 0.4 per cent since late March, reflecting market expectations that if the Fed were to embark on yield curve control, it would target short-term maturities. Such an approach has already been taken in response to the crisis by the Reserve Bank of Australia.
Today’s quiescent bond market buys Fed officials some time, though, and they appear to be using it well. Minutes of the June meeting, released this week, show that “nearly all participants indicated that they had many questions regarding the costs and benefits” of the policy.
One potential benefit is obvious: it would give the Fed a way to keep financial conditions loose, even in an environment in which investors began to anticipate tighter monetary policy. Clearly, officials are uneasy that bond investors could push yields higher, increasing borrowing costs and short-circuiting a recovery in the economy.
But this is where the problems set in. For one thing, yield curve control would send a signal that the Fed’s emergency support measures are fiendishly tricky to unwind. The central bank may want to shrink its balance sheet “once the world gets back to normal”, said Steven Blitz at TS Lombard. But “they can look all they want — there is no exit, especially if fiscal policy ramps up in 2021, as expected”.
The Fed is right to give this and other potential negative side effects serious thought. One key concern is that capping yields — an approach adopted by Japan in 2016 with respect to 10-year bond yields — may not actually work in stimulating inflation. A recent piece of analysis from the Federal Reserve Bank of New York noted a mixed outcome for the Bank of Japan. The policy has not been successful “on the inflation front, at least thus far”, the paper concluded.
Perhaps the most interesting point mentioned in the Fed minutes was a reluctance to create a situation where the use of a yield curve target might mean that monetary policy goals “come in conflict with public debt management goals, which could pose risks to the independence of the central bank”. A government on a borrowing splurge with the certain knowledge that the Fed would jump in to stop five-year borrowing costs breaching, say, 0.4 per cent, could be seen as an overly cozy relationship.
Already, the huge pandemic response from the Fed has aroused concerns about long-term financial stability, and whether an open-ended programme of buying Treasury debt will encourage Washington to maintain hefty levels of spending in the coming years. In the currency market, too, some think the US dollar faces a sharp decline in value stemming from a rising budget deficit, financed with quantitative easing.
In turn, that could limit the appeal of US assets to overseas investors. Hedging currency risk means squeezing returns and in a low-yielding world, that matters. Another consideration is that restrictions on US yields could push domestic investors abroad in search of income.
For now, a global environment of rock-solid government bond prices helps to cap long-dated US Treasury yields without any specific limit set by the Fed. Importantly, inflation expectations remain contained, given the likelihood that the economic output gap sparked by shutdowns will not close for several years. The 10-year note yield remained stuck in its recent range at about 0.7 per cent this week, even after a second straight month of stronger US employment reports.
It is not hard to imagine a renewed bout of downward pressure on yields. The catalyst could be another dip in the US economy or the arrival of a wave of corporate bankruptcies. James Bullard of the St Louis Federal Reserve told the Financial Times this week that a big rise in pandemic-related business failures could still trigger a financial crisis.
William O’Donnell at Citi says he does not think the issue of yield curve control will rush up the Fed’s agenda unless bond prices take a sudden dive from current levels.
For the Fed, large-scale asset purchases and a gently weakening US dollar appear sufficient for now in arresting domestic deflation pressures, which is one-half of its mandate. Plunging into new policies would require the trigger of a new economic shock, which is one most investors should hope does not transpire.