What the Debate Over Fed Minutes Misses on Yield Curve Control

The Fed released the minutes from its July meeting last Wednesday, capping days of unusually high anticipation. Usually Fed meeting minutes are a predictable, rather snooze-inducing affair. But this time, word on the street was that the FOMC had a big discussion about its ongoing inflation target review and how it might change tack to improve its accuracy. One tactic getting frequent mention among financial commentators is yield curve control, which basically amounts to setting targets for long-term interest rates—something the Bank of Japan has done since 2016. As the minutes reveal, that did get a lot of discussion last month, and policymakers decided not to pursue it—at least for now. In our view, this is good news, as adding complicated programs generally increases the potential for error.

The Fed’s view differs from ours. As the minutes sum up, the FOMC “judged  that  yield  caps  and  targets  would  likely  provide only modest benefits in the current environment, as the Committee’s forward guidance regarding the path of the federal  funds  rate  already  appeared  highly  credible  and  longer-term  interest  rates  were  already low. Many of these participants also pointed to potential costs associated with yield caps and targets. Among these costs, participants noted the possibility of an excessively rapid expansion of the balance sheet and difficulties in the design and communication of the conditions under which such a policy would be terminated, especially in conjunction with forward guidance regarding the policy rate.” In other words, they think capping long-term yields is presently unnecessary, given yields are already near historic lows, they fear capping them in the future may require a boatload of bond purchases, and they worry eventually lifting the cap would cause investors to freak out.

We find it rather perplexing that this discussion apparently centered around the possibility of reducing long-term rates further, as that would flatten the yield curve, which is the opposite of stimulus. Japan, by contrast, used long-term yield targets to steepen the yield curve a teensy bit, which led to a stealth tapering of quantitative easing (QE). That made more sense to us. The yield curve, in addition to being a leading economic indicator, influences bank lending. Banks borrow at short-term rates and lend at long-term rates, and the spread between the two is their profit on the next loan made. The wider the spread, the more incentive banks have to lend broadly. But if the spread shrinks, then banks have incentive to lend to only the most creditworthy borrowers, as there isn’t enough of a reward to justify higher risk. Government rates are generally reference rates for deposit rates and lending rates, so a flat yield curve means lending is less profitable and probably less abundant than it would otherwise be.

That isn’t the only reason we don’t see long-term interest rate targets as beneficial. As an excellent Wall Street Journal editorial last month explained, yield targets are just a euphemism for price controls—in this case, the price of US government debt. In a normal, market-driven world, government interest rates fluctuate according to investors’ inflation expectations and perceptions of the issuer’s credit risk. If the Fed effectively controls long-term interest rates, you lose those very helpful market signals. That also interferes with bond pricing globally, as 10-year US Treasury yields are widely considered the “risk-free” long-term rate, which is a reference point for other sovereign and corporate issuers. We reckon markets are efficient enough to get over it, but a distortion is a distortion.

The last time the Fed set the price of government bonds was in the 1940s, when it coordinated with the Treasury for wartime financing and capped 10-year yields at 2.5%. That didn’t end well, as the mandate outlived other wartime price controls, hampering the Fed’s ability to address the hot inflation that inevitably arrived. That wasn’t the sole contributor to the three-year bear market that began in 1946, but it was part of the backdrop. Nor is it a perfect analogue to what the Fed is discussing now, as the Fed wasn’t independent at the time and would theoretically have more flexibility today. But that also means significant room for error as price controls lift. Given the Fed’s history of subpar decisions and unintended consequences, we don’t think it is wise to presume they would be able to enact and then remove price controls with no disruptions.

Even if the Fed would remain nominally independent while enacting long-term bond yield targets, setting the price of government debt strikes us as increasing the risk of politicized monetary policy. It could open the Fed to a huge new avenue of criticism from politicians and potentially undermine the institution’s credibility. We doubt any benefits would emerge from Congress haranguing Fed head Jerome Powell about his interest rate target whenever they want to ramp up borrowing. To see what happens when politicians strong-arm the Fed into doing their monetary bidding, turn your economic history books to the 1970s and stagflation.

So yes, we are thankful the Fed won’t be pursuing yield targets at this time. But they did make a point of leaving the door open. We doubt that possibility is much of a risk for stocks within the foreseeable future, but in general, we think the most beneficial move would be for policymakers to slam that door shut, get back to basics, and let markets do their job.