July 24, 2020
The Simplest To Understand Yield Curve Control
What is Yield Curve Control?
Yield Curve Control (YCC) is an approach to target a longer-term interest rate by a central bank, then buying or selling as many bonds as necessary to hit the rate target. This approach helps to prevent a recession or the impact of a downturn. This would be one way for the Fed to stimulate the economy if bringing short-term rates to zero isn’t enough.
The most different between yield curve control and quantitative easing is that quantitative easing is a trillion-dollar bond purchase and YCC focuses on bond prices.
Example of YCC Practices
The Federal Reserve did its own yield curve control to help the Treasury Department to fund the Second World War in April 1942. In some aspects, the US economic environment at that time was similar to nowadays.
The economy has been recovering from the recession of 1937-38, and by the end of 1941. The output has caught up the time before the great depression. In 1942, the Federal Reserve and Ministry of Treasury had an agreement that the Fed would purchase government bonds with a yield higher than a certain level to limit the borrowing costs of the treasury.
At the time, about ½ percent on 3-month Treasury bills and 2½ percent on longer-term bonds. Until 1947, the Fed was able to maintain these pegged exchange rates without having to purchase large amounts of bonds. The experience showed that asset purchases or similar policies can work.
Recently, the Bank of Japan (BoJ) changed the policy of quantitative easing to YCC at the end of 2016. The bank tried to peg the yield on 10-year Japanese Government Bonds (JGBs) at 0% to stimulate Japan’s economy. When the JGBs increase above the target range, the BoJ will purchase bonds to reduce yield back down.
How YCC Impact on Economy?
The lower interest rates on US Treasury bonds will impact the lower interest rates on mortgages, auto loans, corporate debt, higher stocks, price, and cheaper dollars. All these changes help to encourage businesses and households to spend and invest. The latest research points out that once the federal funds rate drops to zero, fixing the medium-term interest rate at a lower level will help the economy recover faster after a recession.
Like other unconventional monetary policies, the main risk of yield curve policies is that they threaten the credibility of the central bank. This policy requires the central bank to commit to keeping interest rates low for a certain period in the future. This is exactly why they can help encourage spending and investment, but it also means that central banks run the risk of overheating inflation while keeping their promises.