The COVID-19 pandemic led the Federal Reserve to slash interest rates to the zero lower bound (ZLB), provide support to the repo market, and purchase treasuries and corporate bonds, among other tools it has utilized. While the response of the Fed has helped shore up liquidity in the financial markets, it may need to do more as the second wave in the U.S. has led many states to close their economies. This week the FOMC will convene. While the FOMC isn’t expected to make any significant changes to its policy, the meeting may shed light as to whether the Fed is open to implementing other tools it has yet to use, such as yield curve control or YCC.
As the Fed reached the ZLB, it turned to balance sheet related policies such as purchasing government bonds, corporate bonds, and mortgage-backed securities. As a result, within a matter of weeks, the Fed’s balance sheet grew by $3 trillion – a 70% increase from February’s levels. Since June, however, the Fed’s balance sheet has contracted by over $130 billion or close to 2%. This shift in the balance sheet may indicate the markets don’t require as much support from the Fed as they did in March and April.
Despite the ample stimuli and low interest rates, inflation remained well below 2% and may remain low for a long time (inflation has somewhat picked up in recent weeks, but it’s still close to 1.5%). The low inflation and weak labor market will allow the Fed to provide stimulus if needed. And based on the current economic environment, the Fed may require to act. After all, the government stimulus package is still uncertain, and the pandemic continues to rampage in the U.S.
The “cheapest” tool at the Fed’s disposal is forward guidance. I call it “cheap”, because it doesn’t require the Fed to intervene in the markets unless they are stressed. Indeed, the Fed will maintain a dovish outlook to keep the markets in check. As chairman of the FOMC, Jay Powell, stated back in June, “we’re not even thinking about thinking about raising rates”. And sure enough, the bond market seems convinced as rates at the ZLB through 2022.
But forward guidance, regardless of its effectiveness, may not be enough for what the market may need if economic conditions deteriorate further.
The Fed could restart purchasing bonds and support the markets as it did back in March to May. Alas, the Fed isn’t too happy to expand its balance sheet any further. In this case, the Fed could move towards another tool that doesn’t necessarily require augmenting its balance sheet, and that’s yield curve control.
Indeed, the Fed could consider targeting the front-end yield curve and keep treasury bond yields low. Federal Reserve Governor Lael Brainard has already opened the door for YCC in her July 14th, speech:
“Given the downside risks to the outlook, there may come a time when it is helpful to reinforce the credibility of forward guidance and lessen the burden on the balance sheet with the addition of targets on the short-to-medium end of the yield curve.”
In September, the Bank of Japan was the first major central bank to introduce such a policy by targeting the 10-year bond yield at 0%. So far, as a recent post by the Federal Reserve Bank of New York shows, it has been successful in keeping 10-year bond yields at 0% or lower all awhile, reducing the bond purchase pace since then.
As for how much this policy will help the economy is less clear. There hasn’t been a lot of research on this policy. While it could help maintain bond yields low and provide support to the financial markets, it may not be enough to boost economic growth if the economic outlook deteriorates.
The upcoming FOMC meeting will let us know if the Fed is open toward moving in this direction and whether YCC is something Chair Powell is considering as a viable option. If so, it could provide another short-term boost to financial markets.