A novel new approach by the Federal Reserve to stimulate the economy in 2020.
Sometimes I read an article and I’m left with more questions than answers. In this series, we break down trending terms or concepts that need a little more explaining.
Today: Yield Curve Control (YCC)
Federal Reserve officials recently mentioned YCC as another tool to help stabilize the economy.
If you’re familiar with the Federal Reserve’s role in the monetary system, you can skip right through these next sections to “What is yield curve control?”.
The Federal Reserve’s Mandate
The Federal Reserve is the Central Bank of the United States with mandates of (1) 4.5% or lower unemployment rate,(2) 2% inflation rate, and (3) moderate long-term interest rates. See: https://www.federalreserve.gov/aboutthefed.htm
A yield is an interest rate charged for borrowing money for a certain period of time. An example might help us here.
Let’s say you ask me to borrow $100 for only a month and you promise to pay me back. I know you pretty well, trust you, and I’m confident your finances will look the same or better a month from now. It seems low risk so I’d charge you a low interest rate for borrowing. But what if you asked to borrow $100 and you wanted to pay me back after 30 years. That’s pretty risky because a lot can change in 30 years. If I agree to it, I’d want a much higher interest rate to compensate me for that risk.
The Yield Curve
Government bonds (you letting the government borrow your money) can be as short as 1 month to as long as 30 years with many options in between in exchange for the government paying you a yield. Here is the official government website that posts current US Treasury bond rates: https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/textview.aspx?data=yield
Under normal circumstances, short-term bonds have lower yields (aka interest rates) and longer-term bonds have higher yields. Lenders logically require a higher yield for lending their money for a longer period of time. As of the end of May 2020, a 1-month US bond yielded 0.13% and a 30-year US bond yielded 1.41%.
If you plot each rate (yield) at each bond term as a dot on a graph and connect each dot with a line, you have drawn that day’s yield curve.
What is yield curve control?
Usually the government is selling bonds and we are buying them. The amount at which we buy determines the price and rate. The more we buy, the higher the price, and lower the interest rate.
In yield curve control, the Federal Reserve sets a target for the interest rate on specific bonds (it could be the 10 year bond, 20 year bond, etc.). These interest rate targets essentially control the shape of the yield curve. To hit that target, they are prepared to buy those bonds in the market. The government, indirectly, effectively becomes both the seller and a buyer.
This would be similar to an art auction where you are the seller of art, and simultaneously have a friend sitting in the crowd holding a paddle for you. There are multiple pieces of the same art and your friend buys the first piece just set the standard for the next sale. It gets even better, your friend is still in the crowd with your paddle for those additional auctions after the first gets sold, using your own money to bid to pre-determined prices.
While the Federal Reserve isn’t technically part of the federal government, it is overseen and given a blank check by the government. It’s the friend in the crowd artificially setting prices, where money is no object, so that the government get free reign on the money supply.
What are the benefits?
This gives the Federal Reserve the ability to control interest rates and thus stimulate or slow the liquidity in the economy. They can keep raising their paddle if they want to bid the prices up or stop raising their paddle to let them come down by letting others determine the price.
Remember, higher prices of bonds means lower interest rates. Lower rates translates to more economic activity, according to the current school of economic thought.
In this economic climate, the Federal Reserve is considering all options to stave off another Great Depression.