The Fed and YCC: In Everything But Name
This Curve Ain't Peyronie's
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· The Fed’s new strategy, including its labor-centric agenda, and new monetary policy facilities (such as the Standing Repo and Reverse Repo) have created a Fed policy of de facto Yield Curve Control (YCC).
· While the RRF and SRF are talked about primarily as dealing with the money market, in reality they are a means to manipulate the entire yield curve.
· The goal of asset purchases has been expanded beyond “market functioning” to included qualitative outcome-based criteria that are tied to “realized progress” on employment and inflation goals.
· Asset purchases are now effectively discretionary in that they are not tied to any one purpose or indicator. The Fed’s balance sheet has become unhooked from any objective limitations.
· The goal for Powell for the next few meetings will be to slowly move Wall Street away from policy announcements with purchase commitments to a more discretionary approach where purchases are conditioned on economic conditions and bond market behavior.
To little fanfare, a great new project was launched at the “virtual” Jackson Hole economic symposium of August 2020. At the symposium, Chairman Powell announced the FOMC’s new Monetary Policy Strategy. A year and a half earlier, in January 2019, the FOMC began its first ever public review of its monetary policy strategy. In January 2012, the FOMC had issued its first Statement on Longer-Run Goals and Monetary Policy Strategy, which the Committee members refer to as the “consensus statement”. The new strategy, including its labor-centric agenda, and new monetary policy facilities (such as the Standing Repo and Reverse Repo) have created a Fed policy of de facto Yield Curve Control (YCC). The Fed has adopted Bank of Japan policy in everything but name. This note will examine the similarities between the central bank strategies in the U.S. and Japan as well as the inflationary implications of YCC with a policy of “average inflation targeting”.
The Bank of Japan Rollout
In September 2016, Bank of Japan Governor Kuroda unveiled the Monetary Policy Committee’s “Comprehensive Assessment” of its monetary policy strategy, which included a new policy called “Yield Curve Control”. By late 2016, Quantitative and Qualitative Easing (QQE) had been in place for three years and, according to Kuroda, could be considered a success. Kuroda saw four indications that QQE policy had succeeded. First, deflation had disappeared. Second, the levels of corporate profits and sales were at record levels. Third, “excessive” appreciation of the yen had been “corrected” and stock prices had surged.
But, after three years, the two percent target had not been met. Kuroda blamed the “deflationary mindset” for a lack of sustained inflation acceleration and claimed that to “break out” of the mindset the public’s outlook for prices must be altered dramatically. Kuroda asserted, without citing any evidence, that the inflation adaptation mechanism is much stronger in Japan than in other countries.
Prior to YCC, the BoJ was able to push down the entire yield curve using a combination of LSAPs and a negative policy rate. Nominal interest rates had been falling since the introduction of QQE and the pace accelerated after the negative policy rate was introduced in January 2016. But monetary policy was being achieved partly at the cost of lower bank profits and putting insurance and pension solvency at risk.
Under the new framework of “QQE with YCC”, the bank set short-term and long-term interest rates as operating targets. Being able to control the policy rate and the long-term nominal rate creates the potential for “yield curve control”. For the long-term rate the BoJ selected the ten-year JGB. Fixed rate JGB purchases were introduced to ensure a cap on long-term rates.
The old method, using a fixed yen purchasing commitment, created a time consistency issue as well as raising the risk of guessing too high or too low on the purchase size. In a YCC framework, asset purchases are only carried out as needed to hit the yield target. Kuroda also took pains to emphasize that the existing level of asset purchases was “right”. Also introduced was an explicit commitment to overshoot the two percent inflation target. This means monetary policy is backward looking instead of forward facing.
Yield Curve Control and Fiscal Dominance
The goals of YCC as stated by the BoJ was to ensure a positive slope for the yield curve and to overshoot the inflation target. A key footnote in the BoJ announcement states that “In case of a spike in interest rates, the Bank stands ready to conduct fixed-rate JGB purchase operations. For example, those with regard to 10-year and 20-year JGB yields – in order to prevent the yield curve from deviating substantially from current levels.” At the end of the day, liquidity is assured.
The promise to overshoot the inflation target came with the clarification that “price stability” meant that “the inflation rate is 2% on average over the business cycle”. The overshoot commitment is similar to GDP targeting in that the bank is committed to making up for lost ground. No longer are bygones allowed to be bygones when it comes to missing the inflation target.
The effective lower boundary of zero percent means that, with a two-percent inflation target, real interest rates cannot go much below negative two percent. However, with a price level target, inflation expectations can rise as high as needed if credibility is strong. The result being that there is no effective lower boundary on real interest rates.
But yield targeting introduces the risk of balance sheet instability. The bank can target the quantity of a bond it buys or the price it pays for the bonds, but not both. If investors expect the central bank to increase its target rate, they will rush to sell, and the balance sheet will explode. Also, by making its balance sheet endogenous the central bank passes monetary control to the fiscal authorities. The fiscal authority gets to decide how many yield-targeted instruments to issue.
After the announcement of YCC, Kuroda was very explicit acknowledged that the BoJ’s balance sheet had become endogenous. However, according to him, the central bank could remain independent because it could pick any rate it wants. To those who said YCC was too “bold”, Kuroda’s response was that QQE worked because it was considered “bold”.
YCC - The Fed Way
The Fed unveiled a Yield Curve Control framework without calling it as such, probably because targeting Treasury yields has such a controversial history within the Fed. It is also possible that FOMC members are hoping to set up a yield targeting framework without politicians realizing the tantalizing fiscal implications. Fat chance of that happening with Powell’s predecessor at the head of the Treasury Department. Whatever the understanding is behind the scenes, the pieces were not all in place until the Fed had a repo and reverse repo facility in place so that it can play as a buyer and seller at the same time.
Before the repo facilities could be used for yield curve targeting, the Fed had to make the intellectual commitment to a monetary policy framework that makes use of yield-curve targeting. The “New Consensus Statement” served the purpose of putting the FOMC in a position to intellectually justify a policy of intentionally pushing long-term real interest rates deeply into negative territory. No capitalist would make the claim that destroying savings intentionally is a good idea. Only by coming to the conclusion that the private sector floats aimlessly though time is it possible to justify setting the price of money for a ten-year commitment, for example, and then printing money like mad until that price is shown to be intertemporally incorrect. But, when you are deep in a hole the only thing to do is keep digging, as the man once said.
The new consensus bears a striking resemblance to the Bank of Japan’s strategy from 2016. First, the policy explicitly adopts a “flexible average inflation targeting” framework where past shortfalls in average inflation are not considered “bygones”. Price level targeting is now the order of the day. The new framework is based on the assumption that r-star, the “neutral” real interest rate consistent with maximum employment and price stability, has fallen from 2.25% in January 2012 to 0.5% in January 2020 – before COVID.
With r-star so low, it becomes much more likely that the policy rate will fall to zero – or whatever the “effective lower bound” is. According to the FOMC consensus, constantly hitting the zero bound creates the risk of persistent downward pressure on inflation. By implementing an “overshoot commitment”, the FOMC can address inflation shortfalls across the entire business cycle, not only during downturns. Clarida proposes the new framework be called “Temporary Price Level Targeting at the Effective Lower Bound”.
Brainard has taken on the task of selling the social justice merits of the Fed’s new consensus. She emphasized that the employment mandate is now asymmetric with the prior target being “deviations” from maximum employment and the new target being “shortfalls”. Instead of targeting headline unemployment, the FOMC will now be using a “broad-based and inclusive” goal for which “a wide range of indicators are relevant”. Frequently emphasized by Powell and Brainard are the unemployment rates, wage growth rates, and household wealth for Black and Latino workers. Apparently, the board members consider their own opinions on relative wealth distribution among the members of society as valid indicators for monetary policy.
Most importantly, the goal of asset purchases has been expanded beyond “market functioning” to included qualitative outcome-based criteria that are tied to “realized progress” on employment and inflation goals. Asset purchases are now effectively discretionary in that they are not tied to any one purpose or indicator. The Fed’s balance sheet has become unhooked from any objective limitations.
Ghosts of Inflation Past
Whether meant to sell the plan to their political bosses, or because they truly believe the rhetoric, the social justice arguments in favor of an inflation overshoot highlight the obvious political risks of such a strategy. This is not the FOMC’s first time getting in bed with the Treasury for the “sake of the country”. In April 1942, the Fed committed itself to financing World War II by maintaining a peg on the yield of Treasury bonds.
The floor placed under the price of long-term bonds made them as liquid as bills so by 1947 the Fed held almost the entire outstanding stock of Treasury bills. In 1947 and 1948 inflation hit double digits and the FOMC wanted to ditch the Treasury peg. The Fed wanted to raise short-term rates, but the Treasury wanted a floor on the price of long-term securities to continue. With the effective peg on Treasury bonds at 2.5% the Fed was limited on how far it could raise the rate on bills without inverting the yield curve. A recession in the winder of 1948 put the issue on hold but the problem did not go away.
With the outbreak of the Korean War inflation became a threat for a second time. The FOMC argued that five years of post-war growth made a return to the Great Depression unlikely and asked the Treasury to switch to issuing non-marketable bonds that the Fed would not need to buy to maintain a price-floor. The Treasury refused, so in the summer of 1950 after some intense FOMC discussions, the committee decided to just announce its intentions to raise rates rather than ask the Treasury permission. In FOMC minutes “[We are making] it possible for the public to convert Government securities into money to expand the money supply.”
An interesting bureaucratic struggle for power ensued but things really hit the fan when China entered the war. Consumers, expecting wartime rationing, rushed out and made purchases at a frantic pace – sending prices soaring. The FOMC took its argument to Congress looking for political protection against the Treasury Department. “As long as the Federal Reserve is required to buy government securities at the will of the market for defending a fixed pattern of interest rates established by the Treasury, it must stand ready to create new bank reserves in unlimited amount. This policy makes the entire banking system, through the action of the Federal Reserve System, an engine of inflation.” Governor Eccles testimony to U.S. Congress in 1951.
Throughout 1951, the Fed negotiated with the Treasury Department over the so-called Fed-Treasury Accord. The accord laid out the procedure for a smooth exit from the rate peg beginning in 1952. The Fed’s independence from political domination was hard won, but the ease with which political authorities create inflation must have great appeal to an inflation-targeting central banker.
The Final Pieces Fall into Place
After creating massive amounts of excess reserves and finding itself unable to sell the bonds bought to create the reserves, the Fed created the “Reverse Repo Facility”. The RRF provided a means of draining liquidity without having to sell Treasury bonds and risk causing long-term rates to spike. Not surprisingly, the Fed found that once it began draining liquidity there was no way to easily reverse if it went too far. The result was the “Repo-apocalypse” of 2019, which resulted in massive emergency injections of liquidity into the money market.
To deal with “money market liquidity”, the Fed created the Standing Repo Facility (SRF) – which is effectively the opposite of the RRF. While the RRF and SRF are talked about primarily as dealing with the money market, in reality they are a means to manipulate the entire yield curve. The Fed can now quote in both directions simultaneously across the entire yield curve. The mechanics and the dangers are the same as the peg adopted during the war years. The Fed’s balance sheet becomes a machine for the public to convert Treasury bonds into money entirely at its discretion. The central bank’s balance sheet also becomes endogenous to government spending, as Governor Kuroda so rightly pointed out.
Conclusion
YCC was designed to give the BoJ more flexibility in conducting monetary policy, but it came at the cost of a major increase in complexity of conducting policy. Purchases of assets became a tool rather than a target so that discussions about future purchases could be couched in terms of expectations – akin to the policy rate guidance already adopted.
The FOMC’s goal is now to get away from talking about “tapering” in terms of dollars and months and start talking about expected purchases based on yield curve developments. The Bank of Japan was very helpful to the FOMC in figuring out a solution to this little problem. Kuroda’s rollout speech effective told markets to “forget about how many bonds we purchase; we think in terms of yields now”. But the current yield is “about right” and that yield is being achieved under the current rate of purchases – so it’s all good!
The Fed is unlikely to adopt a point target for long-term yields, so the most-likely alternatives are a corridor for the ten-year rate or a corridor for the spreads between the policy rate and the ten-year. Just as it does with the fed funds rate, the Open Market Desk can intervene to keep the shape and level of the yield curve within some acceptable boundaries. The goal for Powell for the next few meetings will be to slowly move Wall Street away from policy announcements with purchase commitments to a more discretionary approach where purchases are conditioned on economic conditions and bond market behavior.
Whether upcoming speeches are “dovish” is immaterial under the new framework because the policy inherently creates an inflation machine. The Fed is setting itself up for political capture by a savvy and partisan Treasury Department. Indeed, if the global economy does slow down, an overtly inflationary policy that partners monetary and fiscal stimulus will look like a lifesaver to the FOMC. But the temptations of inflation past are likely to turn into the political nightmares of the future for the Fed. The Federal government has no shortage of worthless debt that cannot be repaid – student loans, mortgages, pension guarantees, etc. – these will be first in line to be sold to the Fed for newly printed dollars to be recycled into the economy via the fiscal deficit.
References
Brainard, L. “Full Employment in the New Monetary Policy Framework”. https://www.federalreserve.gov/newsevents/speech/brainard20210113a.htm
Cecchetti, S. & Schoenholtz K. “The Bank of Japan at the Policy Frontier”. https://voxeu.org/article/bank-japan-policy-frontier
Clarida, R. “The Federal Reserve's New Framework: Context and Consequences”. https://www.federalreserve.gov/newsevents/speech/clarida20201116a.htm
Hetzel, R. & Leach, R. “The Treasury-Fed Accord: A New Narrative Account”. https://www.richmondfed.org/-/media/RichmondFedOrg/publications/research/economic_quarterly/2001/winter/pdf/hetzel.pdf
Kuroda, H. ““Comprehensive Assessment” of the monetary easing and “QQE with Yield Curve Control”. https://www.bis.org/review/r160928h.pdf
Kuroda, H. “Quantitative and Qualitative Monetary Easing (QQE) with Yield Curve Control": New Monetary Policy Framework for Overcoming Low Inflation”. https://www.bis.org/review/r161021e.pdf
Brookings Institution “A CONVERSATION WITH GOVERNOR HARUHIKO KURODA, BANK OF JAPAN”. https://www.brookings.edu/wp-content/uploads/2016/10/20161008_japan_kuroda_transcript.pdf
Logan, L. “Liquidity Shocks: Lessons Learned from the Global Financial Crisis and the Pandemic”. https://www.newyorkfed.org/newsevents/speeches/2021/log210811
Powell, J. “New Economic Challenges and the Fed's Monetary Policy Review”. https://www.federalreserve.gov/newsevents/speech/powell20200827a.htm
Powel, J. “Monetary Policy in the Time of COVID”, https://www.bis.org/review/r210902e.htm
Williams, J. “The theory of average inflation targeting”. https://www.bis.org/review/r210712d.pdf