Amid its pandemic firefighting, the European Central Bank is ploughing on with a strategic review of its monetary policy framework. One previously neglected idea is coming into the discussion. Pablo Hernández de Cos, Spain’s central bank governor, suggests that the ECB could explore “yield curve control”, or the policy of directly setting long-term interest rates.
It is not a novel policy. Since 2016, the Bank of Japan has committed to keeping the market yield on 10-year Japanese government bonds near zero. The BoJ will buy or sell whatever quantity of bonds is needed to meet this goal.
Targeting long-term rates is an alternative to quantitative easing — mass bond buying — and forward guidance. It achieves directly what QE does indirectly: lower long-term market yields on benchmark securities so as to encourage investors to direct capital elsewhere, ideally to productive investment by businesses wishing to expand. It also directly affects the market cost of borrowing for longer periods, which forward guidance tries to achieve by signalling to markets that central banks will keep short-term rates low for some time into the future.
Why use a tool that gets the same results through other means?
The first answer is that it does so more effectively. Compared with QE, directly targeting 10-year borrowing costs takes the guesswork out of how many government bonds the central bank must buy to achieve what it deems appropriate financial conditions. Compared with forward guidance, direct targeting removes the risk to financial intermediaries that the central bank may not make good on its guidance, and change short rates sooner than it now predicts. This also means the central bank does not hurt its own credibility if it needs to tighten sooner than it thought.
A second answer is that precisely because yield curve control makes little difference to other tools today, now is the least disruptive time to introduce it. At some point policy will need changing, perhaps to tighten in a recovery, or perhaps to offset upward pressure on market rates from US budget stimulus.
In either case, yield curve control would let the ECB move or keep long rates where it sees fit, and avoid politically difficult and technically uncertain deliberation of how many bonds to buy. In fact, Japan’s experience shows that explicitly targeting the 10-year rate reduces the need to buy bonds at all. That should be attractive for the ECB. Its original decisions to engage in large-scale bond purchases were politically excruciating, and thus too slow.
A third argument is that lowering — or lifting — rates is far simpler to communicate to the public than bond purchase programmes in the trillions.
What are the arguments against it? One is that yield curve control falls under the treaty prohibition on credit facilities to governments. But why should 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 eurozone sovereigns, and the ECB currently buys a portfolio of all their debts. But this objection no longer applies. The EU is ramping up the issuance of common European bonds in order to fund its recovery policies. The yield of the 10-year common European bond would be a perfect benchmark for the ECB to target.
This would not address another motive for the ECB’s bond-buying, which is to keep securities markets functioning smoothly, in particular for high-debt eurozone governments. But every economist is familiar with what is known as the Tinbergen rule: for each policy goal you need a dedicated instrument. Market functioning and optimal long-term market rates are different goals. Using yield curve control to achieve the latter leaves bond purchase programmes free to focus on the former.
But yield curve control could have a side benefit, too — one even more important than its main function as a monetary policy tool. Making the common European bond yield an operational target for monetary policy would encourage markets to adopt it as a benchmark for pricing other securities. In time, this would help nudge European banks away from their bias towards holding their own national government’s bonds, a source of instability the ECB and other EU policymakers want to reduce.
Adopting yield curve control today would not just improve monetary policymaking. It would also give significant support to the EU’s policy objective of a banking union. Beyond its price stability mandate, this is a form of support the ECB is treaty-bound to give.
martin.sandbu@ft.com