The Bond Market Versus Yield Curve Control
Bet on the market
The run-up in global bond yields last week is good news in so far as it signals a recovery in expectations for economic growth and inflation. Much of the heavy-lifting was on the part of real yields rather than inflation expectations, the latter having already staged a substantial recovery from the lows of March last year.
As noted on a previous occasion, from where we have been sitting over the last 12 months, rising bond yields and inflation expectations is not a bad problem to have. Inflation expectations are now more consistent with targeted outcomes and not yet suggestive of inflation becoming a problem. A lot of things still must go right before we have reason to fear an inflationary boom of the type Tim Congdon and others have warned about.
Australian bonds underperformed last week, which is consistent with Australia’s economic outperformance. Some suggested the underperformance in the bond market was due to the New Zealand Finance Minister’s direction to the RBNZ MPC to ‘have regard to house price sustainability’ when making its financial stability policy decisions. The thinking seems to be that if the RBNZ is going down this route, the RBA might follow, but I can think of better reasons for the underperformance of Australian bonds last week.
Note that the RBNZ is in a different position to the RBA in having responsibility for prudential as well as monetary policy. In Australia, the former falls to APRA. But in any event, it would seem doubtful the RBNZ will be able to meaningfully operationalise the Ministerial direction and it would be undesirable for it to do more than pay lip-service to it. It is mostly window-dressing. Unless the RBNZ gets into the business of building houses, there is nothing it can meaningfully contribute to housing affordability. Macro prudential tools can certainly be used to penalise investors relative to first home buyers, but substituting between different types of tenure does nothing for overall affordability.
The Ministerial direction to the RBNZ does, however, highlight the fact that NZ politicians give much more thought to the RBNZ’s remit than Australian politicians typically give to the RBA’s. While the numerous changes to the remit over the years have not always been for the better, it shows that the NZ government is at least thinking about the role of monetary and financial policy in realising its policy objectives. Australian politicians would do well to pay greater attention to the agreement with the RBA.
The run-up in yields brought the RBA back into the market to defend its loose peg in the three-year bond of 0.10%. As I noted at the time of its introduction, one of the problems with yield curve control is that it potentially pits the RBA’s credibility against the market, with the prospect that the RBA’s credibility would come off second-best.
A fully credible commitment to hold the cash rate steady out to three years would require no intervention at all. Of course, a fully credible commitment is a bit more than we should realistically expect and the RBA has done well not to have to intervene significantly for much of the period that YCC has been in effect. This is one reason why the RBA initially embraced YCC as an alternative to QE.
But there was always the risk that the market would take a different view of the timing of future changes in the cash rate. In that case, as we saw last week, the RBA might have to intervene more heavily. One of the reasons the US Fed has been wary of YCC is the concern that very heavy intervention might be required in some scenarios, even heavier than seen during QE episodes.
The problem for the RBA is that the market is anticipating inflation and the unemployment rate satisfying the conditions for a lift in the cash rate well in advance of these outcomes being realised, which is the RBA’s threshold condition. In the intervening period, the RBA has to decide whether to maintain and roll-forward the peg to later maturities, possibly requiring some very heavy intervention or letting it go. But letting the peg go would see an effective tightening in monetary policy, even in the absence a change in the target cash rate. This would also flow through to the long-end of the curve, increasing the burden on QE.
An open-ended QE program targeting a target-consistent forecast for inflation and the unemployment rate does not suffer these complications. It can accommodate price signals from the bond market, while still being calibrated to achieve the RBA’s objectives and without putting the Bank’s credibility on the line, inviting a contest with the market.
My guess is that an open-ended QE program straddling the entire curve is where we will end up once YCC collapses. This is, of course, the approach I suggested in my USSC report in mid-2019. The RBA will get there in the end. As Glenn Stevens once said of Australia’s approach to exchange rate management, we tried every managed exchange rate regime known to man before eventually adopting the one that worked.
The great thing about renovating a house in Mosman is that you get to discover your neighbours’ preferences for paint colour and the trees they think you should plant in your garden.