The Federal Reserve Tries to Tame the Yield Curve

As the economy heals, the Fed is worried about long-term interest rates

  • Fed expected to keep interest rates steady at near zero
  • First quarterly economic projections for 2020 on tap
  • Investors look for interest rate guidance, stimulus update
  • Yield Curve Control may be the next step

As expected, the Federal Open Market Committee (FOMC) left interest rates unchanged and implied it would keep them there into 2022, as the economy tries to recover from the recession brought on by the coronavirus pandemic.

In a statement, the FOMC said, "The coronavirus outbreak is causing tremendous human and economic hardship across the United States and around the world. The virus and the measures taken to protect public health have induced sharp declines in economic activity and a surge in job losses. Weaker demand and significantly lower oil prices are holding down consumer price inflation."

The Fed also projected that the economy will shrink 6.5% in 2020, as businesses have laid off tens of millions of workers and industrial and manufacturing activity ground to a halt. However, 2021 is expected to show a 5% gain followed by 3.5% in 2022.

The Fed also pledged to continue its numerous monetary policy procedures aimed at injecting financial liquidity into the banking industry, small and medium sized businesses, government securities and corporate bonds.

The total assets on its balance sheet crossed $7 trillion for the first time last month. (see chart below) "We fully expect that the Fed will be as dovish as necessary to avoid a mini "taper-tantrum," keeping the peak-virus trade nicely on track," wrote OANDA analyst Jeffrey Halley this morning

balance sheet
Source: The Federal Reserve.

There's been increasing speculation that the central bank will use yield-curve control (YCC) or interest rate caps for the first time since the 1940s to clampdown on rising Treasury security rates/yields and keep borrowing costs low for businesses and consumers. 54% of economists surveyed by Bloomberg believe this tactic will be on the table in September, but we may hear hints about it today. Federal Reserve Bank of New York President John Williams said in March policy makers are "thinking very hard" about YCC.

With quantitative easing, the bank promises to buy large quantities of bonds, but with YCC it focuses on the price of bonds to flatten the yield curve. With YCC, the Fed would set a target rate for a bond with specific maturity and vow to buy as much as necessary to keep the rate there. The Bank of Japan is the only major central bank to have experimented with interest rate pegs in recent history, according to think tank Brookings, and it has purchased far lower quantities of government bonds since then. Australia adopted a form of this policy in March when it set a target for the yield on 3-year Australian Government bonds of around 0.25%. 

"Interest rate pegs theoretically should affect financial conditions and the economy in many of the same ways as traditional monetary policy: lower interest rates on Treasury securities would feed through to lower interest rates on mortgages, car loans, and corporate debt, as well as higher stock prices and a cheaper dollar," wrote Brookings economists. "If investors believe the Fed will stick to the peg, the Fed could achieve lower interest rates without significantly expanding its balance sheet."

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