This commentary was written by Dr. Daniel Thornton of D.L. Thornton Economics. Thornton spent over three decades at the St. Louis Fed as vice president and economic advisor.
At the Fed’s June 10 press conference (here) Chairman Powell acknowledged the Federal Open Market Committee (FOMC) was considering other approaches for conducting monetary policy including “targeting interest rates along the yield curve.” Yield curve targeting, as it’s called, is price fixing.
Historically the Fed has been opposed to price fixing. This essay describes what it means to control the yield curve, what the Fed might attempt to achieve by adopting this policy and the likelihood it will work.
The interest rate is the price of credit. Fixing the interest on a security fixes the price of that security. Prices provide information that producers and consumers use to make decisions. Prices also determine the allocation of economic resources.
Price fixing short circuits the flow of information and causes a misallocation of resources.
Furthermore, the shape of the yield curve provides information about the economy: Long-term rates tend to increase relative to short-term rates during good times and tend to fall relative to short-term rates during bad times.
Indeed, long-term rates have often gone below short-term rates—the yield curve becomes inverted—before and during recessions.
At the Fed’s June 10 press conference (here) Chairman Powell acknowledged the Federal Open Market Committee (FOMC) was considering other approaches for conducting monetary policy including “targeting interest rates along the yield curve.”
Yield curve targeting, as it’s called, is price fixing. Historically the Fed has been opposed to price fixing. This essay describes what it means to control the yield curve, what the Fed might attempt to achieve by adopting this policy and the likelihood it will work.
The interest rate is the price of credit. Fixing the interest on a security fixes the price of that security. Prices provide information that producers and consumers use to make decisions. Prices also determine the allocation of economic resources. Price fixing short circuits the flow of information and causes a misallocation of resources.
Furthermore, the shape of the yield curve provides information about the economy: Long-term rates tend to increase relative to short-term rates during good times and tend to fall relative to short-term rates during bad times. Indeed, long-term rates have often gone below short-term rates—the yield curve becomes inverted—before and during recessions.
The figure above shows three general shapes of yield curves: ascending, flat, and inverted.
The ascending yield curve is the most common shape historically. This one occurred on May 7, 2004. The flat yield curve occurred on August 8, 2007, and the inverted yield curve occurred on August 23, 2019.
The inverted yield curve around this time gave rise to concerns the economy might be going into a recession. [The Treasury provides the yield curve data daily here, so you can look at the yield curve for any date you’d like from 1990 to the present.]
“Ok, so what is yield curve control and why would the FOMC want to adopt it?” As the name implies, yield curve control means controlling the shape of the yield curve. However, controlling the interest rate for every maturity along the yield curve is impossible.
As practical matter, yield curve control means controlling two rates along the yield curve; a shorter-term rate and a longer-term rate. “Yield curve control” is an inaccurate description of what the Fed would do. The Fed will not attempt to “control” the longer-term rate. Rather, it would attempt to put a ceiling, or cap, on it.
The Fed will allow the long-term rate to go below the ceiling, but attempt to prevent it from going above the cap. The Fed has essentially controlled the overnight federal funds rate since it adopted the federal funds rate as its policy instrument in the late 1980s (see Greenspan’s Conundrum). Hence, the Fed would implement this new policy by trying to control a longer-term Treasury rate as well.
The maturity of the longer-term interest rate the FOMC will choose to cap depends on what the FOMC is trying to achieve. It is widely accepted that long-term interest rates are most important for spending decisions. Consequently, if the objective is to have a larger effect on spending decisions, the FOMC will attempt to cap a long-term rate, most likely the 10-year Treasury yield.
However, Loretta Mester, President of the Federal Reserve Bank of Cleveland suggested that she sees yield curve control as a tool to support the Fed’s forward guidance policy, here. Forward guidance means committing to keep the funds rate low for a longer period of time in an effort to reduce long-term interest rates (see How Effective Is Central Bank Forward Guidance?).
Forward guidance is based on the belief that long-term rates are determined by market participant’s expectation for the short-term rate over the holding period of the long-term security. This is called the expectations hypothesis (EH). Policymakers believe this in spite of the facts that: (1) The EH has been massively rejected empirically over a variety of time periods and interest rates. Indeed, it is massively rejected when the federal funds rate is the short-term rate (see Tests of the EH: Resolving Anomalies When the Short-Term Rate is the Federal Funds Rate). (2) Interest rates are essentially impossible to predict beyond a few weeks.
For the EH to be true, market participants would have to behave irrationally. They would have to price long-term securities based on their expectation of an interest rate they know they can’t predict (see Predictions of Short-Term Rates and the Expectations Hypothesis).
To see how the policy would be implemented, suppose the FOMC decided to cap the 10-year Treasury yield at 1.5% at its July 28-29 meeting. The Fed would implement the policy by purchasing whatever quantity of 10-year Treasuries they needed to purchase at the price needed for the yield to equal 1.5%.
If the 10-year Treasury rate was at or below 1.5%, the Fed would do nothing. However, if the rate went above 1.5%, the Fed would purchase all of the 10-year Treasuries it needed to in order to keep the rate at 1.5%.
Putting a ceiling on a longer-term rate will distort interest rates further out on the yield curve and result in a misallocation of resources. I know because I have shown in Greenspan’s Conundrum, that the FOMC’s adoption of the federal funds rate as its policy instrument in the late 1980s distorted the behavior of Treasury rates.
Indeed, when the FOMC reduced its federal funds rate target aggressively to the then historically low level of 1% in June 2003 and kept it there for a year, it distorted rates out to five years.
At the March 16, 2004, FOMC meeting, Donald Kohn, then vice chairman of the Federal Reserve, noted that the FOMC’s low interest rate policy was distorting the allocation of economic resources. He made this prophetic statement:
We have attempted to lower interest rates below long-term equilibrium rates and to boost asset prices in order to stimulate demand. But as members of the Committee have been pointing out, it’s hard to escape the suspicion that at least around the margin some prices and price relationships have gone beyond an economically justified response to easy policy. House prices fall into this category...If major distortions do exist, two types of costs might be incurred.
One is from a misallocation of resources encouraging the building of houses, autos, and capital equipment that won’t prove economically justified under more normal circumstances. Another is from the possibility of discontinuities in economic activity down the road when the adjustment to more-sustainable asset values occurs.
Consistent with Kohn’s concern, residential construction spending declined from a peak of $684 billion just before the home-price bubble burst in 2006 to $240 billion when the recession ended in June 2009. It remained at about that level until March 2012, when it began its slow accent. Residential construction spending is still below its 2006 peak. Not surprisingly, employment in construction followed a very similar path.
There is no doubt that the massive overproduction of housing contributed to a decade-long anemic-economic-growth expansion, which the FOMC tried unsuccessfully to combat by keeping its funds rate target low (see Common Sense Reasons Interest Rates Don’t Matter for Policy).
The good news is that it is unlikely the FOMC will adopt “yield curve control” at its next meeting or, perhaps, anytime soon. The yield curve is currently very flat; the 5-year rate is just 34 basis points and the 10-year rate is just 74 basis points. The FOMC is unlikely to set a cap for the 10-year Treasury rate as long as it remains under 1.5%.
Nevertheless, it is worthwhile to consider whether the FOMC could successfully cap the 10-year yield. The FOMC has successfully controlled the federal funds rate. But the federal funds market is relatively small, about $150 billion a day. Moreover, only banks and a few other institutions, which are permitted to have deposits in Federal Reserve Banks, can participate in the federal funds market.
In contrast, the market for long-term debt, of which 10-year Treasuries are a small but significant part, is very large and international in scope. Hence, if market participants believed that the Fed wouldn’t purchase the amount of 10-year Treasuries it need in order to enforce the rate cap, the FOMC would be forced to increase the cap. The FOMC would be forced to adjust the cap whenever the market dictated that the 10-year rate be higher than the FOMC’s cap.
The Fed would monitor the market closely, so it might be able to increase the cap sufficiently fast that it could claim the increase was a policy action, even though it was simply responding to the dictates of the market.
But I doubt it could do it all the time.
In case you are skeptical that this could happen, I have shown (On the Fed’s (In)Ability to Affect Interest Rates) that rising interest rates forced the FOMC to increase its target for the federal funds rate 125 basis points in five moves starting on December 13, 2017, and to subsequently reduce the target by 75 basis points beginning June 19, 2019. The FOMC and the media portrayed these changes as “policy actions.”
James Bullard, President of the Federal Reserve Bank of St. Louis, even claimed that the 2019 cuts in the FOMC’s federal funds rate target were responsible for the 144 basis point drop in the 2-year Treasury rate (here).
The truth is the reverse.
Such behavior is likely to be much more frequent and, perhaps, far more obvious, should the FOMC decided to cap the 10-year Treasury rate.
If the FOMC tries to do it and its failure is obvious, the market will increasingly come to see the FOMC’s interest rate policies for what they are: ineffective, damaging and dangerous!
This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.