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In the midst of its fight against the pandemic fires, the European Central Bank is pursuing a strategic review of its monetary policy framework. A previously overlooked idea enters the discussion. Pablo Hernández de Cos, Governor of the Spanish Central Bank, suggests that the ECB could explore “control of the yield curve”, or the policy of direct fixing of long-term interest rates.
This is not a new policy. Since 2016, the Bank of Japan pledged to keep the yield on the Japanese 10-year government bond market near zero. The BoJ will buy or sell the quantity of bonds necessary to achieve this objective.
Long-term rate targeting is an alternative to quantitative easing – purchase of mass bonds – and forward guidance. It directly achieves what QE does indirectly: lower long-term market yields on benchmarks in order to encourage investors to direct capital elsewhere, ideally to productive investments by companies wishing to grow. It also directly affects the cost of borrowing in the market for longer periods, which foresight attempts to achieve by signaling to the markets that central banks will keep short-term rates low for some time in the future.
Why use a tool that achieves the same results in other ways?
The first answer is that it does it more efficiently. Compared to QE, directly targeting 10-year borrowing costs avoids guessing how many government bonds the central bank must buy to obtain the financial terms it deems appropriate. Compared to forward-looking indications, direct targeting removes the risk for financial intermediaries that the central bank will not meet its forecasts and changes short-term rates sooner than currently expected. It also means that the central bank is not damaging its own credibility if it has to tighten sooner than it thought.
A second answer is that precisely because controlling the yield curve makes little difference to other tools today, this is the least disruptive time to introduce it. At some point, policy will have to change, perhaps to tighten in the event of a recovery, or perhaps to offset the upward pressure on market rates. Stimulation of the American budget.
In either case, controlling the yield curve would allow the ECB to move or hold long rates where it sees fit, and avoid politically difficult and technically uncertain deliberations on the number of bonds to buy. . In fact, the experience of Japan shows that the explicit targeting of the 10-year rate reduce the need buy bonds at all. This should be interesting for the ECB. His initial decisions to engage in large-scale bond purchases were politically atrocious and therefore too slow.
A third argument is that lowering – or raising – rates is much easier to communicate to the public than trillion-dollar bond buying programs.
What are the arguments against? The first is that control of the yield curve falls under the treaty ban on government credit facilities. But why would targeting long-term market rates be less acceptable than buying huge amounts of government bonds to achieve the same result?
Another objection is that there is no obvious long-term bond yield to target. There are 19 sovereigns in the eurozone, and the ECB is currently buying a portfolio of all of their debts. But this objection no longer applies. The EU is stepping up the issuance of common European bonds in order to finance its recovery policies. The yield on the 10-year common European bond would constitute a perfect benchmark for the ECB.
This would not address another motive for the purchase of bonds by the ECB, which is to keep securities markets functioning smoothly, especially for heavily leveraged eurozone governments. But every economist knows what is called the Tinbergen rule: for each political objective, you need a dedicated instrument. The functioning of the market and the optimal long-term market rates are different objectives. Using yield curve control to achieve the latter allows bond buying programs to focus on the former.
But controlling the yield curve could also have a secondary advantage – even more important than its primary function as a monetary policy tool. Making the yield on the common European bond an operational objective of monetary policy would encourage markets to adopt it as a benchmark for pricing other securities. Ultimately, this would help steer European banks away from their tendency to hold their own national government bonds, a source of instability that the ECB and other EU policymakers want to reduce.
Adopting yield curve control today would not only improve monetary policy making. It would also provide significant support to the EU’s political goal of a banking union. Beyond its mandate of price stability, this is a form of support that the ECB is required to provide.
martin.sandbu@ft.com
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