How does yield curve control work?

Many readers had difficulty understanding my recent post on interest rates, exchange rates and monetary shocks. That’s probably because most of us have been brainwashed to think of monetary policy in terms of interest rates.

Suppose that 30-year bond yields are 2%. Then the Fed suddenly announces a plan to peg the 30-year bond yield at 1%. What happens?

The interest parity condition tells us that the 30-year forward exchange rate should appreciate roughly 30% relative to the spot exchange rate (ignoring compounding effects.) That sounds highly contractionary, and indeed it might be highly contractionary.

But what really matters is what happens to the 30-year forward exchange rate in absolute terms. If the spot exchange rate depreciates by more than 30% on the news, then the 30-year forward rate might actually depreciate, even as it appreciates relative to the spot exchange rate. Dornbusch overshooting.

Thus when there is a “yield curve control” announcement, you want to look at the impact on forward exchange rates in absolute terms. If the policy is successful (i.e. expansionary), then the forward exchange rate should depreciate in absolute terms.

Yield curve control is a stupid way to do monetary policy, although it’s conceivable that it’s slightly less stupid than what they are currently doing, which is to let inflation fall below the 2% target during a severe recession.



24 Responses to “How does yield curve control work?”

  1. Gravatar of FP FP
    2. July 2020 at 01:15

    I’m confused: with either parity condition the expected rate of depreciation is unchanged, as the current spot rates are unchanged. What am I missing?

  2. Gravatar of George George
    2. July 2020 at 03:26

    Why do we need the Fed?
    The economy was doing just fine before 1913 right?
    I’m trying to follow the nominal vs real debate here, but is this not just substituting one bad policy, for perhaps a slightly better policy?
    Like Ron Paul, I’m a physician. And his book “end the Fed” seems to be quite logical and persuasive – at least to a laymen.

  3. Gravatar of Rajat Rajat
    2. July 2020 at 04:31

    Yet another fascinating post. But ultimately, it feels unsatisfying to not have a definitive answer. Perhaps the reason a definitive answer is hard is because this is a very tricky thought experiment. I think that if the adoption of YCC is truly exogenous and 100% credible, it should have a roughly neutral impact. The 30yr yield would move immediately to 1%, the central bank would need to buy no assets, the spot exchange rate would appreciate 30% and the forward exchange rate would remain unchanged. But YCC would never be implemented under such conditions. In the real world, I see two conflicting forces:
    First, a bit like a fixed $ amount of QE-at-large (like QE1 and 2), YCC is a gesture towards expansionary policy. It reflects a mild but unfocussed desire to promote higher inflation. Second, YCC may be regarded as a means of achieving some of the apparent indicia of easy policy but without the central bank having to buy too many assets, either where local government bonds are in short supply (as in Australia) or where the central bank already owns a sizeable share of local bonds (as in Japan). Under these circumstances, it may look like a cop-out. It’s like Chuck Norris has come into a room and just asked people to be quiet rather than told them to leave. The room might sound empty, but he can’t snooze like he would if the room had been cleared. If markets were hoping for ‘whatever it takes QE’ + a level target or even just open-ended QE and get YCC, it’s likely to be contractionary. I would say that given recent experience with central banks doing QE and talk of temporary level targets, adoption of YCC would have to be a disappointment on net.

  4. Gravatar of Rajat Rajat
    2. July 2020 at 04:44

    So, Scott, yes, relative to the situation 5 minutes before it is announced, I accept that the immediate forward currency effect tells us whether the policy is relatively expansionary or contractionary. But so much is baked into expectations by that 5 mins-before point in time that I would regard any move toward YCC as a lost opportunity and failure in the broader scheme of things.

  5. Gravatar of rayward rayward
    2. July 2020 at 05:20

    I get it: the announcement by the Fed creates more demand for 2% bonds, which is contractionary. But isn’t the announcement also expansionary in that it signals the Fed’s belief that the economy is lagging and needs stimulus (thus, the lower interest rate so businesses and households will have more incentive to borrow and spend). When the Fed announces that it will do “whatever it takes” to prevent stock prices from falling, do investors sell because the Fed is signaling a likely drop in prices or do investors buy because the Fed is signaling it won’t let prices drop? All of this has a reading the tea leaves quality to it. What would a clever man do?

  6. Gravatar of ssumner ssumner
    2. July 2020 at 07:59

    FP, The change in interest rates equals the change in the expected rate of depreciation.

    George, That’s a big topic. In 1913 we had an international gold standard. Today, we do not. So we can’t go back to 1913 without global cooperation.

    Rajat, Yes, I think I agree with that. I’d emphasize that it may depend on a wide variety of factors that are not well understood. We aren’t used to policy shocks being multidimensional.

  7. Gravatar of Ray Lopez Ray Lopez
    2. July 2020 at 09:49

    @Rajat – free your mind, I once had your mental blocks brother. Money is neutral, short term and long. The Fed follows, it does not lead the market. When it leads, it usually has no effect (1994 in the USA, a few years ago with demonetarization of small bills in India, even arguably revaluing the Swiss franc in January 2015, notice at Trading Economics the Swiss GDP was on a downward trend since 2014 anyway). No effect. Money is always and everywhere neutral.

    @Everybody: (Sumner): “Yield curve control is a stupid way to do monetary policy, although it’s conceivable that it’s slightly less stupid than what they are currently doing” – stupid he says; Sumner refuses to let monetarism and the US Fed take credit for the historic QE-infinity announcement in mid-March, which turned around the stock market, and the economy. Amazing. Even when handed a clear win, Sumner manages to snatch defeat out of the jaws of victory. Even “money is neutral” me was amazed by the March Fed announcement and its effect but it doesn’t faze Sumner, nor blunt his criticism of the Fed. Mind boggling.

  8. Gravatar of eskimoeskimo eskimoeskimo
    2. July 2020 at 10:44

    I think a potential market monetarist response would be that the stock market rally has more to do with _current_ Fed timidity, rather than a policy stance that is adequately expansionary.

    The broad USD rates complex, including low TIPS breakevens, and the continued weak performance of cyclical sectors within the equity market (look at, say, the underperformance of financials vs. the tech-heavy Nasdaq) all point to a low nominal growth recovery.

    There is an old Wall Street saying that the best environment for stocks is a dull, slow economy that the Fed is trying to get going. And the market sees a dull, slow economy in which the Fed will have to continue extending policy for years to come. Stocks, but particularly growth names, software etc. command eye-wateringly high valuations in such a low inflation and low real-rate world.

    If the Fed were actually expansionary in their policy stance, not only would we be seeing higher real and nominal rates, but more money would be looking to finance real capital investment, thereby decreasing the rich valuations and razor-thin risk premiums we currently see in financial assets.

  9. Gravatar of Benjamin Cole Benjamin Cole
    2. July 2020 at 17:31

    Dr. Ray Lopez: recent US Federal Reserve monetary policies have been complemented by large national federal budget deficits. In addition, it appears the Federal Reserve balance sheet may be a permanent condition, that is, will be no reduction in the Federal Reserve balance sheet going forward. This looks suspiciously close to money-financed fiscal programs (as advocated by Stanley Fisher and perhaps David Beckworth), or MMT.

    The astute observer can delve into the current economic situation and policy responses to support any pre-approved narrative.

    I am interested in Scott Sumner’s idea that the Federal Reserve should target a lower exchange rate for the US dollar. The Swiss National Bank has established a ceiling on the Swiss franc, but determining an impact on the actual Swiss economy is somewhat uncertain, made even muddier by the current C19 debacle.

  10. Gravatar of ssumner ssumner
    2. July 2020 at 17:31

    Ray, Toyota got to be number one (before Tesla) through relentless quality improvement. Never rest on your laurels.

    The Fed’s getting better, but there is always room for improvement. So I keep lighting a fire under their feet.

  11. Gravatar of Ricardo Ricardo
    2. July 2020 at 18:05

    Off-topic. If you haven’t seen this … this crazy guy, Hugh Hendry, who’s a “global macro advisor” was on Bloomberg recently, he sounds like a Scott Sumner monetarist. Two reasons why: (1) here’s the money quote (pun intended), “I would rather we radicalize the Federal Reserve than radicalize the political economy”: (2) Earlier in the video, he says the Fed needs somebody from outside that can credibly promise to be irresponsible; citing that in the past few months the Fed’s balance sheet has expanded from $4T to $7T and the markets just yawned. I assume he means that the Fed would not have not needed a nearly 50% balance-sheet expansion if only they could have credibly jawboned their intentions.

  12. Gravatar of Thomas Hutcheson Thomas Hutcheson
    2. July 2020 at 19:02

    What’s confusing is discussing monetary policy in any terms except whether the Fed is fulfilling it’s mandate: maximum employment and 2,5% PCE inflation.

    It’s looking more and more like the fall in NGDP is due to consumers and investors shifting to near money, not firms that cannot fill consumers and investors demand. But let say the Fed just does not know what full employment is right now and so does not feel obliged to do anything to increase employment. But PCE inflation has been, is, and is expected to continued to be less than 2.5% (and if there is ANY real supply component to the fall in NGDP, PCE inflation ought to be above 2.5%) What conceivable reason does it have for allowing this to continue.

  13. Gravatar of Maryann Maryann
    2. July 2020 at 20:29

    How about a creating reading list Scott?
    What books do you recommend?

  14. Gravatar of ssumner ssumner
    2. July 2020 at 21:36

    Ricardo, I like this quote:

    “I would rather we radicalize the Federal Reserve than radicalize the political economy”

    Maryann, Books on what subject?

  15. Gravatar of Postkey Postkey
    3. July 2020 at 01:11

    “Equation (22) indicates that the change in government expenditure ∆g is countered by a change in private sector expenditure of equal size and opposite sign, as long as credit creation remains unaltered. In this framework, just as proposed in classical economics and by the early quantity theory literature, fiscal policy cannot affect nominal GDP growth, if it is not linked to the monetary side of the economy: an increase in credit creation is necessary (and sufficient) for nominal growth.
    Notice that this conclusion is not dependent on the classical assumption of full employment. Instead of the employment constraint that was deployed by classical or monetarist economists, we observe that the economy can be held back by a lack of credit creation (see above). Fiscal policy can crowd out private demand even when there is less than full employment. Furthermore, our finding is in line with Fisher’s and Friedman’s argument that such crowding out does not occur via higher interest rates (which do not appear in our model). It is quantity crowding out due to a lack of money used for transactions (credit creation). Thus record fiscal stimulation in the Japan of the 1990s failed to trigger a significant or lasting recovery, while interest rates continued to decline. ”

  16. Gravatar of ssumner ssumner
    3. July 2020 at 08:03

    Ben, You said:

    “I am interested in Scott Sumner’s idea that the Federal Reserve should target a lower exchange rate for the US dollar.”

    I’m interested in what makes you think I favor targeting the dollar exchange rate?

  17. Gravatar of Nick S Nick S
    3. July 2020 at 13:45

    Easy why Ben would think that. You favor targeting NGDP, of which RGDP is a component, of which net exports is a component, of which is influenced by the dollar exchange rate.

  18. Gravatar of Benjamin Cole Benjamin Cole
    3. July 2020 at 15:48

    Scott Sumner: yes I know you favor NGDP LT and achieved primarily through monetary policy (no Stanley Fischerian fiscal facilities operated by the Fed).

    But if the US Fed adopts a truly expansionary monetary policy, ceteris paribus, we should see a lower exchange rate of the US dollar.

    It is an interesting topic. Suppose the Fed took a page out of the Swiss National Bank’s book and targeted a ceiling on the dollar?

    As a side note, suppose the Fed acquired a balance sheet of 20 trillion dollars of non-US sovereign bonds?

  19. Gravatar of ssumner ssumner
    4. July 2020 at 08:12

    Ben, If the Fed adopts a truly expansionary monetary policy, then we should see a higher price of zinc. Do I favor using monetary policy to target zinc prices?

  20. Gravatar of Nick S Nick S
    4. July 2020 at 09:20

    RE: “ Ben, If the Fed adopts a truly expansionary monetary policy, then we should see a higher price of zinc. Do I favor using monetary policy to target zinc prices?”

    Yes, implicitly…. along with the price of an arbitrarily selected basket of goods that you can measure with a different ruler if you don’t like the results yielded by the first ruler. Great… now we have an arbitrarily selected basket of goods that costs more. Not to mention how the price of zinc is rocketing upward. Success! Back to economic growth and prosperity!

  21. Gravatar of Benjamin Cole Benjamin Cole
    5. July 2020 at 04:10

    Scott Sumner well, I don’t know if you are still reading, but the Swiss National Bank seems to think there is a reason to cap the exchange value of the Swiss franc, and doing so will have a positive macroeconomic effect inside Switzerland.

    So, I assume there are intelligent people at the Swiss National Bank, who may have different opinions from you or me, but they seem to be applying a strategy.

    I think the exchange rate of a currency has more macroeconomic implications than the sale price of zinc.

    You may wish to reconsider and flush out this topic at a future date— exchange rates, that is, not zinc prices.

  22. Gravatar of ssumner ssumner
    5. July 2020 at 09:10

    Nick, I give up with you. It’s like talking to a rock.

  23. Gravatar of Nick S Nick S
    6. July 2020 at 21:22

    Scott- you have not made a single thought provoking counter to any point I have made in any thread. Id be more than happy to debate your garbage ideas (which haven’t caught on for good reason) anytime, anywhere, by any medium.

  24. Gravatar of Nick Nick
    7. July 2020 at 03:22

    “Yield curve control is a stupid way to do monetary policy, although it’s conceivable that it’s slightly less stupid than what they are currently doing, which is to let inflation fall below the 2% target during a severe recession.”

    do you dislike yield curve control because it does most (purchasing) when you need to do least, and does least when you need to do most? or what is the reason you dislike?

    i dislike that element a lot, i also dislike that you now destroy whatever feedback the market could have given you.

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