Slippery Slope Ahead for RBA’s Yield Management Strategy

This article appeared on Australian Financial Review on May 13, 2020.
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Federal Reserve officials are fond of touting the importance of independence in the conduct of monetary policy. In theory, they want to avoid politicisation and maintain a firm boundary line between monetary and fiscal policy in pursuing their dual mandate of full employment and price stability.

In reality, however, the Fed is an agent of Congress — or more precisely, a fiscal agent — and, in a crisis, is subservient to the Treasury.

During World War II, for example, the Fed supported the prices of US securities and pegged interest rates at artificially low levels to finance government deficits. The pegged rate system didn’t end until 1953, even though the Treasury‐​Fed Accord was announced in 1951.

Today, in response to COVID-19, the Fed has once again become a major player in funding massive increases in government deficits. It has promised to more than double the size of its balance sheet by engaging in large‐​scale asset purchases of Treasuries and mortgage‐​backed securities.

The Fed also has created off‐​balance sheet entities — special purpose vehicles — backstopped by the US Treasury with funds appropriated by Congress under the CARES Act (Coronavirus Aid Relief and Economic Security Act).

Congress has provided the Treasury with $US454 billion ($700 billion) to cover potential losses from the Fed’s emergency lending programs. That backstop will allow the Fed to lend as much as $US4.54 trillion.

Although the Fed — unlike the Bank of Japan and, more recently, the Reserve Bank of Australia — has not officially pegged interest rates on government debt, there has been talk of establishing “yield curve control”. The idea is to have the Fed commit to buy longer‐​terms bonds to support their prices, and thus peg their yields at whatever rate is decided upon, most likely under consultation with the Treasury.

Although the Fed may see this as a way to stimulate the economy, it could also be a way to fund fiscal deficits at an artificially low rate.

According to Sage Belz and David Wessel, of the Brookings Institution, “a major risk associated with yield‐​curve policies is that they put the central bank’s credibility on the line” — that is, if the Fed promises to peg rates, it runs the risk of straying from its inflation target.

In the case of Australia, the central bank has set a 0.25 per cent target for the yield on three‐​year government bonds, which meshes with the cut in its cash rate target.

The Reserve Bank distinguishes its yield control approach from quantitative easing. Rather than announce a target for the quantity of bonds it plans to buy, it says it will buy an unlimited quantity of government bonds to keep the bond yield at its targeted low rate.

Governor Philip Lowe has also promised 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”.

He expects the cash rate “will remain at its current level for some years”. The problem is, central bankers don’t have perfect information. Consequently, forward guidance has not worked very well.

The real economy has a mind of its own and central bank forecasts have a poor track record.

When central banks peg rates and try to control the yield curve, they may reduce the quantity of bonds they need to purchase in the short run, if the central bank has credibility, but investors will be incentivised to search for yield by moving to longer‐​term securities.

This shift increases duration risk — that is, when the economy starts to recover and interest rates rise, holders of longer‐​term securities will suffer large losses.

By engineering lower rates and promising to keep them low for several years, the central bank encourages politicians to continue to run fiscal deficits.

Pegged rates also distort the allocation of credit by diminishing the role of private markets. Placing legal ceilings on interest rates (i.e. not allowing them to rise above the maximum rate targeted by the authorities) — and thus supporting bond prices — is not a panacea for creating a robust economy.

Most importantly, once rates are pegged at artificially low levels, they can be difficult to exit.

Politicisation of central bank policy will diminish independence and harm credibility. If inflation increases, there is always the danger of wage‐​price controls and a loss of economic freedom. Future economic growth will suffer.

Those adverse consequences of pegged rates should not be lost sight of in fighting the COVID-19 pandemic.

The pandemic was not the fault of central banks, nor was the political decision to lock down the economy and put millions of people out of work. In such a situation, the Fed and other central banks had to act quickly and decisively to provide liquidity - to prevent financial instability from leading to further deterioration of the real economy.

Yet unconventional monetary policies are meant to be temporary, not permanent. Ensuring long‐​run economic growth necessary to restore economic wellbeing will require adapting to new realities via markets, not manipulating interest rates to finance government deficits and providing cheap credit to favoured groups.

James A. Dorn

James A. Dorn is vice president for monetary studies, editor of the Cato Journal, senior fellow, and director of Cato’s annual monetary conference.