The minutes of the June FOMC meeting reveal that the Fed is leaning toward enhanced forward guidance and away from yield curve control, at least for now. That said, the combination of forward guidance and the potential for yield curve control should continue to hold down the front to medium end of the yield curve for the foreseeable future.
FOMC participants discussed policy options when rates are pinned to the effective lower bound (ELB). The staff first briefed participants on the impacts of outcome-based forward guidance and large-scale asset purchases. This type of guidance links policy to specific economic objectives. The staff presented:
…results from model simulations that suggested that forward guidance and large-scale asset purchases can help support the labor market recovery and the return of inflation to the Committee’s symmetric 2 percent inflation goal. The simulations suggested that the Committee would have to maintain highly accommodative financial conditions for many years to quicken meaningfully the recovery from the current severe downturn.
Not surprisingly, the degree of effectiveness hinges on the capacity of the Fed to influence forward-looking expectations of firms and households. A more “prompt and forceful” policy stance could focus those expectations more effectively and accelerate the impact. Still, and most important for financial markets, is that the Fed would need to “maintain highly accommodative financial conditions for many years to quicken meaningfully the recovery from the current severe downturn.” In other words, we are in this for the long haul in the best-case scenarios where the Fed can accelerate the recovery.
The staff also briefed participants on the experience in the U.S., Japan, and Australia with yield curve control. The staff:
…noted that these three experiences suggested that credible YCT policies can control government bond yields, pass through to private rates, and, in the absence of exit considerations, may not require large central bank purchases of government debt.
But the staff also fretted that yield curve control might require the Fed purchase large quantities of debt such that “monetary policy goals might come in conflict with public debt management goals.” This is of course the type of situation the Fed fears as they perceive that fiscal authorities will strip the Fed of its independence should the Fed desire to raise rates. For what it’s worth, I am not convinced that this argument does not already apply to the existing quantitative easing regime. If the Fed wanted to pull back on the pace of asset purchases now, they might find themselves at the mercy of a Congress unhappy that the Fed basically cleared the way for expansive fiscal policy and then reneged.
Participants agreed that they had experience with asset purchases and forward guidance and that these are effective tools. They leaned toward outcome-based forward guidance and indicated that more guidance would be needed in the coming months, so be ready for it. A number of participants argued for tying policy to inflation outcomes. This stands in contrast to the original Evans rule which included both inflation and unemployment outcomes. The focus on inflation reflects the lessons learned in this past recession The Fed arguably tightened policy too early based on unemployment outcomes that pessimistically suggested inflationary pressures that did not become manifest. Given uncertainty about the strength of the Phillips Curve, the Fed appears to be leaning toward setting policy more heavily on inflation outcomes.
There was also a nod toward average inflation targeting in that the objective could “entail a modest temporary overshooting of the Committee’s longer-run inflation goal but where inflation fluctuations would be centered on 2 percent over time.” I think this foreshadows a shift toward average inflation targeting in the upcoming policy review.
A minority argued for an unemployment target or calendar-based guidance. A couple fretted about financial stability. I don’t think these views will dominate future discussions.
Regarding large scale asset purchases, participants believe these were also effective but were limited in current circumstances by the decline in natural real rates, the term premium, and the current low level of rates. It’s a pushing on a string argument. That said, asset purchases are still beneficial because they prevent unwanted increases in longer-term interest rates and act to reveal the Fed’s commitment to accommodative monetary policy. Per usual, there were a few concerns about financial stability.
In contrast to forward guidance and asset purchases, yield curve control did not get a lot of love from FOMC participants. Primarily, it appears the Fed did not think it necessary as long as forward guidance was effective. Then there were a number of concerns about actual implantation:
In addition, participants raised a number of concerns related to the implementation of YCT policies, including how to maintain control of the size and composition of the Federal Reserve’s balance sheet, particularly as the time to exit from such policies nears; how to combine YCT policies—which at least in the Australian case incorporate aspects of date-based forward guidance—with the types of outcome-based forward guidance that many participants favored; how to mitigate the risks that YCT policies pose to central bank independence; and how to assess the effects of these policies on financial market functioning and the size and composition of private-sector balance sheets. A number of participants commented on additional challenges associated with YCT policies focused on the longer portion of the yield curve, including how these policies might interact with large-scale asset purchase programs and the extent of additional accommodation they would provide in the current environment of very low interest rates. Some of these participants also noted that longer-term yields are importantly influenced by factors such as longer-run inflation expectations and the longer-run neutral real interest rate and that changes in these factors or difficulties in estimating them could result in the central bank inadvertently setting yield caps or targets at inappropriate levels. A couple of participants remarked that an appropriately designed Y
Here’s my take: Quantitative easing as a fundamental part of the tool kit was not quickly embraced by the Fed, yet policymakers have come to embrace it. Yield curve control will follow the same pattern. Assume the economy limps along with high unemployment. The Fed will be under pressure to do something. They will have a choice between expanding the balance sheet further with expanded asset purchased or:
appropriately designed YCT policy that focused on the short-to-medium part of the yield curve could serve as a powerful commitment device for the Committee. These participants noted that, even if market participants currently expect the federal funds rate to remain at its ELB through the medium term, the introduction of an effective YCT policy could help prevent those expectations from changing prematurely—as happened during the previous recovery—or that the size of a large-scale asset purchase program, which also poses risks to central bank independence, could be reduced by an effective YCT policy.
They will choose yield curve control. Hence, I think we should continue to view yield curve control as a credible option and the existence of that option combined with the upcoming enhanced forward guidance will keep the front to medium end of the yield curve locked down.
A couple of other points in the minutes are notable. First:
A number of participants judged that there was a substantial likelihood of additional waves of outbreaks, which, in some scenarios, could result in further economic disruptions and possibly a protracted period of reduced economic activity.
This scenario is already occurring in states such as Texas and Arizona. I continue to expect that the future is one of rolling shutdowns that weigh on overall economic growth. The state level response is not consistent and federal leadership is, shall we say, lacking.
A second point is that the Fed foresees permanent damage to the economy:
As part of their discussions of longer-run risks, participants noted that in some adverse scenarios, more business closures would occur, and workers would experience longer spells of unemployment that could lead to a loss of skills that could impair their employment prospects. In addition, to the extent that transmission-mitigation procedures adopted by firms reduced their productivity, or if the reallocation of industry output resulted in a lasting reduction in business investment, the longer-run level of potential output could be reduced.
The reference to productivity indicates a concern not just about a level-shift to potential output, but a trend-shift. This reduced pace of potential output growth hasn’t shown up in the SEP yet, but participants are thinking about the possibility.
Bottom Line: The Fed isn’t ready for yield curve control just yet, but that doesn’t mean it isn’t coming. I suspect that they will move in that direction, but it probably won’t come until 2021 (assuming unemployment doesn’t look likely to quickly recede). Between now and then, be ready for outcome-based forward guidance focused on inflation.