Yield Curve Control does not provide any inflation control

By 3 minute read

The Fed will meet later this month - an uneventful gathering would be my guess. However, many Fed watchers are building a case for additional measures to be taken by the Fed later this year, especially the possible announcement of Yield Curve Control (YCC) for bonds with a maturity up to 3-5 years. Some Fed members have also recently mentioned YCC as a central bank tool, so it’s time to dig up some dirt about it.

In November 2018, the Fed announced it would do a full review of its monetary policy framework. At that time, the Fed board hung the "mission accomplished" banner in its meeting room as both inflation and employment were near the Fed's objectives (unemployment had fallen below 4% and core inflation averaged 2% in the second half of 2018, so the targets were as good as achieved). They mentioned that the structure of the US economy had changed and as a result they were getting perilously close to the zero bound in the last recession, a problem that might be even more severe in future downturns. As a result, they needed to check whether an update/expansion of the Fed's toolbox is necessary. Interestingly, they did not mention that the whole world had changed in the last few decades and that there were plenty of global forces that are not under the Fed's control. I would say that today, US inflation, like so many US consumer goods, is made in China (and Germany and other global exporters) rather than homemade. Reading the Fed review announcement several times did not make a difference. It clearly states that the Fed has a dual inflation and employment mandate and it will be able to continue to meet them with a few policy and communication tweaks.

Is there a point in trying to push up inflation?

The Fed is not the only central bank wrestling with achieving its inflation target, the BoJ has missed them for a couple of decades and the ECB is not doing much better nor expected to achieve them any time soon. Practically all developed market central banks have seen inflation running (far) below their targets throughout the last decade. Now, instead of thinking about the reasons and consequences of global "lowflation", central banks are sending their economists back to the drawing board to figure out how to push their local inflation numbers upwards. Even worse, no central bank is mentioning or discussing the downside effects of trying to achieve this inflation target, unless forced by some rogue judges in Karlsruhe. And to wrap it all up, they keep on measuring inflation as the price of a ham and egg sandwich, instead of (seriously) including house price inflation and also start to include all kind of consumption taxation which pushes down true disposable income.

Try to explain to a Hong Kong millennial that inflation is low and stable while he cannot afford to buy or rent even a 100 square foot apartment and has to stay with his parents another 20 years. Or a teacher in Amsterdam that we are very sorry he cannot get a mortgage to live anywhere near his work, but that inflation is really too low and the ECB has to buy more Italian bonds to get to its goal. I will also not apply for a position in the BoJ board, because I would not be able to keep a straight face and claim that in a couple of years we will be able to reach 2% inflation. So to wrap it up, if it was my turn to review central bank targets, I would both lower the target and also include house prices and other asset prices in this target.

Watch out for adverse effects of YCC

Back to the Fed, what is it likely to do in its upcoming meetings? Well, the US is not exactly winning the war on corona at this moment so they will certainly sound very cautious on the economic outlook in these meetings. Apart from wearing masks in public to provide a good example there is not a lot the Fed board can do to improve the immediate outlook. To me it is a bit surprising that they are not buying more treasuries, but the market is doing the heavy lifting for them with the 10-year yield hovering around 60 bps and rates volatility still very depressed. The Fed has done YCC before, but that was during/after World War II and was meant to keep yields from rising as the government deficit exploded, a very effective strategy indeed. This time YCC would be installed to show the Fed means business to achieve its inflation target. But just as most QE programs, YCC would subsequently prove to be ineffective in pushing up inflation levels and have more success in pushing up asset prices.

The BoJ example shows that starting YCC may have a reverse effect on a central bank balance sheet. Since the announcement of YCC around zero percent yield for Japanese 10-year government bonds, the BoJ has bought a lot less of them, as investors have sufficient appetite to keep rates at this level. So instead of expanding its balance sheet further, the BoJ has handed control over its balance sheet to the investor community and had to slow its printing press. I think the same would happen in the US if the Fed would announce YCC in September. The US 5-year government bond trades at 30 bps and has been moving in a 5 bps range for weeks already. The Fed can claim it wants to keep it below 30 bps until core inflation reaches 2%, in my view that would not be a big deal. How much should the 10-year rate move on this announcement from its current level of 60 bps? PM's might lengthen the duration of their portfolios a bit and as a result the 10-year rate can fall 10-20 bps. Will this move the price of a ham and egg sandwich now or in the future? No. Will it encourage investors to take more risk in equity and real estate markets? Yes. Will this result in bubbles and other future financial market mess? Very likely. YCC is clearly not the answer for me.

Hendrik Tuch

About Hendrik Tuch

Head of Fixed Income