What the FOMC Really Thinks About Australia’s Yield Curve Control

The Fed wants to do more; the RBA, not so much

The minutes of the June FOMC meeting show that the Committee discussed what it called yield curve caps or targets (YCT), also known as yield curve control. The Australian experience was discussed as being ‘most relevant for current circumstances in the United States.’ The minutes note that Australia’s very own Ed Nelson, Senior Adviser in the Division of Monetary Affairs, was present for this discussion, so we can assume that the consideration of the Australian experience was well-informed.

The FOMC’s consideration of YCT was in the context of a broader discussion of additional tools that could be employed ‘to support forward guidance and complement asset purchase programs,’ which are the two main monetary tools currently employed by the Fed, putting aside the alphabet soup of credit policy measures being used in parallel with monetary policy.

The key issue being addressed by the Committee is whether stronger forward guidance tied to specific inflation and/or unemployment outcomes or calendar-based guidance is needed to maintain the desired market expectations for the Fed funds rate (I would strongly favour the former over the later, but there is clearly some support for the latter on the Committee). YCT is relevant in this context because ‘an effective YCT policy could help prevent those expectations from changing prematurely – as happened during the previous recovery – or that the size of a large-scale asset purchase program, which also poses risks to central bank independence, could be reduced by an effective YCT policy.’

This is consistent with the way in which the RBA thinks of YCT. As we have argued in this space previously, YCT aimed at the 3-year bond yield is partly designed to reinforce the commitment on the cash rate should the market view that commitment as less than fully credible and to avoid having to expand its balance sheet by doing QE. Liquidity operations aside, the RBA only purchases bonds if the market takes a different view of the future cash rate. But we are left to wonder whether it’s the commitment on future path of the cash rate that is credible with the market or merely the threat of intervention to defend the peg. With the 3-year bond yield no longer free to float, we are denied useful information from that part of the curve.

An important difference between the Fed and the RBA is that for the Fed, YCT is seen a tool for doing more by strengthening forward guidance and complementing QE, whereas for the RBA, YCT is designed to draw a line under monetary policy’s contribution, at least for now. The RBA says it is open to doing more, but shows little enthusiasm for it.

Both the Fed and RBA have similar forward guidance in place. For the FOMC, the Fed funds rate will be maintained at 0.00-0.25% until the FOMC is ‘confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.’ Price stability is defined in terms of ‘its symmetric 2% inflation objective.’

For the RBA, the guidance is that ‘the Board will not increase the cash rate target until progress is being made towards full employment and it is confident that inflation will be sustainably within the 2–3 per cent target band.’ This is little different from the pre-pandemic guidance that official interest rates would remain ‘low’ for ‘an extended period.’

The June minutes suggest that any strengthening of forward guidance by the Fed will be in the context of the conclusion to its monetary policy framework review and any revisions to the Statement on Longer-Run Goals and Monetary Policy Strategy.

My own guess is that the FOMC will strengthen forward guidance by tying it to an inflation outcome and only consider YCT if such guidance is not seen as credible by the market. But as with the RBA, once YCT is in place, we will no longer have signals from the controlled part of the curve as to whether monetary policy is either credible or working effectively. As we have argued in other contexts, effective monetary policy should have dynamic effects on market expectations consistent with higher, not lower yields.

Ironically, YCT policies could lead to much heavier Fed or RBA intervention at precisely the point when it is no longer needed. If markets starting pricing in recovery and anticipating future tightening ahead of actual central bank policy actions, they could be forced to intervene more heavily to defend any YCT. By the same token, a worsening in the outlook requiring even lower yields may see any peg challenged as a floor in yield rather than a ceiling. As the June FOMC minutes note, YCT ‘could result in the central bank inadvertently setting yield caps or targets at inappropriate levels.’ More importantly, it prevents policymakers from obtaining market feedback on their actions.

Scott Sumner argues that ‘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.’ This is the March 2023 AUD-USD futures contract on CME. The RBA adopted YCT on 19 March.

Scott argues that ‘yield curve control is a stupid way to do monetary policy, although it’s conceivable that it’s slightly less stupid than what [the FOMC] are currently doing, which is to let inflation fall below the 2% target during a severe recession.’ But Australia shows that YCT is no guarantee against a monetary policy conditioned on a forecast of below target inflation for the next two years.