Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Saturday, August 29, 2020

Some thoughts on yield curve control

There's been a lot of talk about "yield curve control" (YCC) as of late. I found the recent exchange between Joe Weisenthal and David Beckworth (with many others chiming in) very interesting:

A number of us gathered on Zoom to discuss the subject. What follows is my own take on YCC and some of the issues involved. If you're interested in joining in on a future Zoom discussion, let me know.  

One thing I learned from the people I talked to is that my notion of YCC seemed to differ from the way they were thinking about it. Most people seem to have in mind the idea of YCC as a form of interest-rate peg, only with the fixed peg applying to interest rates at all maturities, for example, in the manner of Fed policy over the period 1942-47 and 1948-51.

In contrast, I view YCC as a state-contingent policy that pegs (or sets a narrow corridor for) rates at all maturities. The slope of the curve may be held fixed, with policy determining the level shifts in the yield curve (so, basically an extension of the Taylor rule applied to interest rates at all maturities). Or policy could also change the shape of the curve, making it steeper or flatter (so, basically replicating "Operation Twist" type interventions). Let me distinguish this notion of YCC by labeling it RBYCC (rule-based YCC).

What is the rationale for RBYCC? The RB part has the standard rationale. But what's the point of YCC then? The way I look at things is as follows. For some odd reason, the Treasury finances the deficit by issuing U.S. Treasury Securities (USTs) with different maturities. These securities are nominally risk-free. But if they all constitute risk-free claims to cash (reserves), then why do/should these objects sell at different prices? And even if there is some "preferred habit" force at work, why doesn't the treasury exploit the apparent arbitrage opportunity, selling securities that trade at a premium (typically bills) and repurchasing securities that trade at a discount (typically bonds). Indeed, why even issue securities that the market discounts (a polite way of saying hates) in the first place? (I offer one rationale here: Maturity Structure and Liquidity Risk).

If by "liquidity" we mean the ability to convert a security in reserves (or bills), then it is clear that the liquidity of USTs is a policy choice. It would be a simple matter for the Fed and/or Treasury to set up a standing facility prepared to buy/sell USTs of any maturity on par with reserves, for example. This policy would have the effect of eliminating discounts across all securities. If you don't like this policy, then you'll have to explain why it's a good idea for government securities to trade at discounts relative to each other. To me, this is like saying a $10 bill should be discounted relative to two $5 bills. (Note: I am not saying such an argument does not exist--indeed, my paper above makes one such argument.)

The effect of RBYCC would be to render all USTs equivalent to reserves (which itself leads to the question of why deficits can't be financed entirely with interest-bearing reserves). The same would be true of YCC with a fixed pattern of discounts, as in the U.S. from 1942-47. This much was recognized by Friedman and Schwartz in their Monetary History when they wrote "The support program converted all securities into the equivalent of money" (pg. 563). In theory, this type of policy should work as well or better than simply targeting the short rate. It eliminates the liquidity premia on government debt (i.e., it satiates liquidity demand) and it permits the usual sort of Taylor rule to stabilize the economy.

As mentioned above, however, most people probably think of YCC as a peg-like policy. One argument against interest rate pegs is that they induce instability. The U.S. experience over 1942-47 and 1948-51 is widely interpreted as having promoted excess inflationary pressure. Let me briefly review those episodes here. 

At the time, the Fed set the short rate at 3/8% and capped a long rate at 2.5%. Measured inflation remained low, thanks to wartime wage and price controls. Interestingly, the 2.5% cap seemed non-binding. It is likely that long yields remained low because investors expected the Fed to keep the short rate low for the indefinite future. We know that at the time, investors were selling bills to the Fed and acquiring higher-yielding bonds to exploit the apparent arbitrage opportunity (see Chaurushiya and Kuttner, 2004). Inflation only took off once wage and price controls were lifted in 1946. While this burst of inflation was likely only temporary, a concern over inflation led the Fed to raise the short rate to 1% in late 1947 when inflation had already declined from 20% to 10%. Inflation then stabilized for about a year at 8%, before declining sharply to 2.75% in 1948. At this time, the economy went into a recession, lasting until the last quarter of 1949. The inflation rate fell below zero in May 1949 and stayed below zero until July 1950 (so, well over a year of deflation). 

Let me summarize this episode. Under this YCC policy, inflation fell from a peak of 20% in March of 1947 to about 10% in November of 1947 with the bill rate still pegged at 3/8%. Then, with the rate hike pegged at 1%, inflation continued to fall rapidly, hitting a low of negative 3% in August of 1949 (near the end of the recession). It took until June 1950 for inflation to rise to 0%. 

Inflation then began to rise rapidly after June 1950 – the month the United States entered the Korean War. The Treasury wanted to keep interest rates low to facilitate war finance. The Fed favored high interest rates to combat inflationary pressures created by the war. Inflation peaked in early 1951 at 9.5%. Chaurushiya and Kuttner, 2004 write:

“It became abundantly clear during this period that the interest rate caps were hampering the Fed’s ability to achieve its monetary policy objectives and, in particular, its efforts to contain rapidly rising inflationary pressures.”

This experiment in YCC ended with the Treasury Accord in March 1951. And the narrative that YCC is is inconsistent with inflation control was born.

My own interpretation of these events and of the efficacy of YCC is as follows. First, it seems a bit of stretch to "blame" inflation over this episode as the consequence of YCC. For most of the 1942-51 period, the U.S. was at or recovering from war. Wars are known to place great fiscal strain on governments and financing a war effort with higher-than-normal inflation is likely desirable from the perspective of optimal public finance policy. That is, the U.S. would have likely experienced higher-than-normal inflation under any reasonable interest rate policy. 

I interpret the interest rate hike in 1947 as an example of how RBYCC can work to control inflation. In this example, the short rate was increased to 1% and the long-rate remained capped at 2.5%, in effect flattening the yield curve. The disinflationary impact of this rate hike seems evident in the data above. So, it seems clear that RBYCC can be used to control inflation, even if it seems to have been employed rather clumsily in 1947. 

As usual, looking forward to your comments/criticisms, which can be left below.