Easily the most interesting takeaway from Federal Reserve Chairman Jerome Powell’s testimony this morning before the Senate Banking Committee came in his response to a pointed question from Pennsylvania Republican Senator Pat Toomey on yield curve caps:
*** In response to skeptical questioning by several Republican senators, Chairman Powell repeatedly stressed the Federal Open Market Committee is only at the “early stages” of its debate over yield curve caps. But he also made, almost as an aside, two additional points that offered a revealing glimpse into the Fed’s early thinking about YCC: first, that if yields are rising, for whatever reason, and the Fed wanted them lower to remain accommodative, then YCC would be considered, and second, that if YCC were introduced, they would be applied “somewhere along the curve” rather than across the entire curve as was the case during and immediately after the Second World War. ***
*** Those comments to us, however, also raise a potentially complicated dilemma on the timing and likelihood of YCC: to be effective, YCC would optimally be introduced with the revisions to the monetary policy playbook to reinforce the lower for longer rates guidance for maximum credibility, which many in the market, including ourselves, think is likely in September (see SGH 5/19/20 “Fed: On the Transition to Monetary Policy” and SGH 6/10/20, “Fed: From Here to September). But the Republican concerns with YCC suggests to us there is a not insignificant risk the Fed may want, or need, to delay introducing YCC until after the November elections or indeed, to opt for the less politically sensitive open ended QE. ***
Only at an “Early Stage”
Powell was very carefully non-committal in his response to Senator Toomey’s question on whether the Fed was considering adopting yield targets, stressing how the Fed was only at an “early stage” of evaluating the merits of yield curve control. To underscore that point, Powell noted the Federal Open Market Committee meeting last week heard a briefing by staff on the “history” of yield curve management during and immediately after the Second World War, as well as a brief survey of the more recent experience with the Bank of Japan and the Reserve Bank of Australia. “We’ve made absolutely no decision to go forward on it,” Powell affirmed.
And in response to a later YCC question from North Carolina Republican Senator Thom Tillis, Powell made a reference to the example of the Fed review of negative rates to repeat the point that the FOMC was only in the early stages of its evaluation of the merits of YCC as a policy tool: “In the same way we’ve looked at negative rates repeatedly… but in the case of negative rates, we’ve pretty much decided that it is not something we think is attractive for us here in the United States.” Yield curve control is very much at the same early stages of debate, and education for the Committee, which will “then decide whether we think it might under some circumstances be useful.”
In itself, those remarks were neatly in line with his YCC messaging at last week’s presser and the recent comments by his FOMC colleagues. But Chairman Powell did also make a point it appeared to push back, however gently, against the skeptical tones of how Senator Toomey phrased his question to leave the YCC door open: “the sense of it is that if …. rates were to move up a lot….for whatever reason, and we wanted to keep them low, to keep monetary policy accommodative, we might think about using it, not on the whole curve but at some part of the curve.”
Several points leap out for us on those comments, and on the debate more broadly over the potential adoption of YCC:
The first is that if the FOMC should embrace YCC, they are very likely to pick a point nearer the short end of the curve, along the lines of a cap on three-year rates that governor Lael Brainard suggested in recent speeches. A credible cap out to three years, if messaged well, would neatly reinforce a lower for longer rates guidance that would extend across the three-year forecasting horizon of the rate dot plot and the Summary of Economic Projections.
Indeed, the heart of the attraction to YCC, even if it potentially means a loss of control over the balance sheet, is if well messaged and credible it could mean less expansion of the balance sheet than an open-ended QE.
YCC Most Effective before a Rise in Yields
But that ultimate pay-off with YCC goes to the issue of the timing on when to introduce the cap if that is the policy path chosen by the FOMC. And on that point, our sense is that Chairman Powell may have been less careful than he should have in holding the door open by noting the conditions under which the YCC would be considered.
While it would be unfair to take the Chairman’s rapid response in the heat of a hearing as Gospel, our sense is that the Fed staff believe that if the Fed were to embrace yield curve caps, the time to do it is exactly when yields are not under pressure and already rising, but in a period of relative calm. It would probably be a policy error, in other words, to turn to YCC only after yields are rising, as it could prove to be costly in terms of the amounts the Fed might need to purchase to defend the cap, and its credibility. We suspect there may be some clarification down the road at some point.
Optimally, then, the YCC would be unveiled early on, with the introduction of the new monetary policy playbook, to ensure the high-stakes commitment to buy whatever amount of treasuries is needed to defend the capped price comes from a position of strength and maximum credibility; like timing an FX intervention when the trend is in your favor as opposed to when the currency is moving hard against you.
Against the backdrop of the surging coupon volumes of US Treasury debt issuance slated to hit the market in the second half of this year, the optimal moment for the FOMC to unveil its new monetary policy playbook may indeed be at its September meeting as is now being widely assumed. That would of necessity mean the broad contours and objectives of the new policy framework are already well telegraphed, and a long runway of messaging the merits of yield curve caps has already been laid down by then.
A Risk of Delay?
But juxtaposed against that timeline, we were struck by the sharp skepticism in the phrasing of Senator Toomey’s question about yield curve control, “concerns [over] manipulating Treasury yields…picking borrowers over lenders…[and] problems for insurance funds and pension funds and…price signaling.” Furthermore, he asked implicitly, how does the Fed exit from the caps without triggering the volatility it is seeking to dampen down to extend a long period of accommodation?
Toomey is in fact hardly alone in his concerns, both inside the Fed system and the wider markets. More to the point in our minds is the potentially loaded politics of introducing yield curve caps, however pitched as a technical move, in the waning weeks of what is certain to be a highly polarized presidential election. It opens the possibility the Fed may be hesitant about turning to YCC until after the elections.
A later than expected introduction of YCC could risk a steepening in yields due to market uncertainty over the Fed’s intentions. But with some controversy still over the policy, and especially if the economy is stalling out and in need of more assertive easing, a return engagement to open-ended QE could be the calculation as the more effective, and safer, means of using the balance sheet to reinforce its lower for longer rates guidance.
No wonder, then, that Chairman Powell repeatedly stressed the FOMC is some way from its final decision on YCC.