Yield curve control

Stopping central banks from being prisoners of financial markets

Central banks are on the front lines in the fight to limit the impact of the pandemic. They are supporting virtually every aspect of the economy and the financial system. Combined with the massive fiscal support, these policies restored market stability, safeguarded financial institutions, and reduced suffering. Count us among those who firmly believe that everyone would be in worse shape had central banks and fiscal authorities not coordinated this aid as they did.

But, by providing such a broad backstop, the reliance of financial markets on that support can itself become a source of instability. This raises a set of very important and pressing questions: Have central banks’ actions over the past year made financial markets their masters? Can policymakers now be counted on to suppress financial volatility wherever it arises?

We surely hope not, but we see this as a legitimate concern. Fortunately, we also see a solution. Central bankers should strive to duplicate the success of their framework for interest rate policy. That is, they should be clear and transparent about their reaction function for all their policy tools. Knowing how policy will react, markets will respond directly to news regarding economic conditions, and less to policymakers’ commentary. Of course, central bankers cannot ignore shocks that threaten economic and price stability. But cushioning the economy against large financial disturbances does not mean minimizing market volatility….

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Helicopters to the Rescue?

Is helicopter money here? Do we need it now? Is it coming? The short answer to these questions is that it is not here and we currently do not need it, but should the economic disaster brought on by COVID-19 continue for much longer, that might change.

To be clear, the relief checks that governments are sending out to households and businesses are not helicopter money. Despite their enormous scale, the financing of these transfers is no different in character from that of traditional government benefits: governments are collecting taxes and issuing debt to the public.

Helicopter money is when the central bank finances government expenditure directly. In these circumstances, the fiscal authority, through its debt management policies, controls the size of the central bank’s balance sheet. This is monetary finance arising from fiscal dominance: to increase seignorage, the fiscal authority usurps the role of the independent central bank in determining the size of base money (currency plus reserves held by banks at the central bank).

Should monetary policymakers consider surrendering their independence in this way? In our view, a far better alternative is to peg the long-term interest rate at zero. Currently in use by the Bank of Japan, this policy of yield curve control allows central banks to retain a small, but significant degree of monetary control. It also captures the features of U.S. monetary policy from 1937 to 1951, when the Fed capped the long-term bond yield to support U.S. wartime finance (see here)….

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