Let’s start with the basics: Historically, central banks have resorted to interest rate cuts as a means of boosting economic growth, since lower financing costs spur borrowing and investment. However, with short-term rates now close to zero, slashing them further is not an option, unless central banks want to push rates into the red – punishing savers and pension funds and denting bank profitability. Another avenue still open to central banks is therefore Yield Curve Control. This tool can be used alongside traditional monetary policy measures to shape long-term interest rates.
So how does it work? In a nutshell, Yield Curve Control – or ‘YCC’ for short – is where central banks set a target for longer-term interest rates and then promise to buy as many bonds as needed to achieve that target. Technically speaking, they are influencing the shape of the yield curve to prevent long bond yields from rising above a defined ceiling.
For YCC to function effectively, there is one key ingredient: Credibility. Market players need to believe that the central bank means business and will buy up bonds as promised if interest rates start to creep above the target level. This credibility helps to stabilize expectations and keep rates where central banks what them. So far, so good. However, problems can arise if that credibility evaporates – dampening demand for bonds, dragging down prices and driving up yields.
So that is how it all works on paper – but is anyone actually putting YCC into practice? If we look east, we can see two examples of this tool in action: The Bank of Japan adopted YCC in 2016 and has since succeeded in keeping long bond yields close to zero. And the Reserve Bank of Australia introduced YCC as recently as March 2020 as part of a package of measures to curb the rise in long-term yields.
YCC is dramatically different to the US Fed’s usual way of managing the economy by setting a key short-term interest rate. Nevertheless, the Fed has recently scrutinized this approach – though its enthusiasm has now faded and the measure is on ice. Interestingly, the Fed is no stranger to YCC: in 1942, it tried to control the yield curve for almost a decade with varying degrees of success. The big difference is that back then, its main goal was to finance wartime spending at low interest rates – not propel an ailing economy forward.
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