What is Yield Curve Control
Yield curve control is the policy that the Fed (or any central bank that adopts YCC) will set a target bond yield of a specific maturity, then buy or sell as many government bonds as necessary until the bond yield hit the target rate.
Normally, bond prices and bond yields are inversely correlated, as the price of a bond rises its yield fall, but when the price of a bond falls its yield will rise. Buying bonds increase their demand, which increases the price. This is how the central bank like the Fed purchases bonds to lower interest rates through YCC.
For instance, on March 19, 2020, the Reserve Bank of Australia (RBA) announce to maintain the 0.25% target on 3-year bonds. That time the RBA purchased the 3-year bond for 1 billion Australian dollars, as the 3-year yield was slightly above the target yield. Further purchases will continue if the yield deviates from the target rate.
Yield curve control (YCC) is a tool to control interest rates along some portion of the yield curve. Historically, the Fed, Bank of Japan (BoJ), and Reserve Bank of Australia (RBA) use yield curve control to stimulate the economy during the central bank’s nominal interest rate target is near zero which is unable to cut the interest rate further. The policy can thus help align market expectations with the FOMC’s expectations.
Yield Curve Control (YCC) vs Quantitative Easing (QE)
The main difference between yield curve control (YCC) and quantitative easing (QE) is that QE has no specific bond yield target, but YCC requires the target bond yield of a specific maturity to maintain.
With quantitative easing, the central bank will commit to stimulating the economy by purchasing a specific amount of bonds or securities to support asset prices per month. Yield curve control has a specific bond yield target of a specific maturity to purchase until the bond yield hit the target rate, this causes the central bank can achieve lower interest rates with a much smaller balance sheet than QE.
On March 19, 2020, the Reserve Bank of Australia (RBA) implemented YCC by purchasing bonds worth 52 billion Australian dollars to maintain the 0.25% yield on 3-year bonds. The purchases occurred between March 19 and May 6; purchasing stopped until August 5-6, when the central bank purchased just 1 billion Australian dollars, as the 3-year yield was slightly above the target.
Drawbacks of YCC
However, yield curve control has drawbacks. First, if the central bank were to adopt such a policy and if the public perceives that the central bank is engaged in deficit financing, then it is possible that inflation expectations could rise.
Second, is the worry that YCC could distort market signals, thereby diminishing the value of information that monetary policymakers glean from the Treasury market.
Finally, if the Fed were to adopt a yield curve control policy, policymakers would have to grapple with the challenge of how to exit from policies designed to be temporary departures from normal. Thus, once the economy normalizes, it would be important to convey the yield curve control exit strategy to the public in a clear manner to avoid potentially destabilizing outcomes.
Thus, credibility is the key to YCC.
References: Federal Reserve Bank of St. Louis, Federal Reserve Bank of Chicago