Different target, different issues
Typically, the form of QE is for a central bank to target a specific quantity of bonds to purchase. This quantity is usually specified well in advance, with the central bank buying the bonds in the secondary market – usually in the form of a reverse tender.
But this is not the only option. Recent commentary has raised the possibility the RBA might choose to target the price (yield) rather than the quantity of bonds. This is a legitimate choice.
The Bank of Japan (BoJ), for instance, introduced its Yield Curve Control (YCC) policy in 2016. This aimed at targeting a level of 0 per cent for the 10-year JGB, with the policy to be in place until the 2 per cent inflation target was achieved.
A yield target requires an unconditional commitment to purchase whatever level of bonds is required. Without that commitment, the target lacks credibility. So one of the drawbacks of yield targeting is the central bank may lose control over the size of its balance sheet.
If, however, the central bank’s actions have credibility, it is possible that the yield curve target can be achieved with minimal bond purchases. This 2018 paper notes the BoJ has been able to achieve an outcome close to its stated target with fewer purchases of JGBs over time. This may have partly been due to the BoJ’s long history of significant bond purchases.
A central bank that makes its initial move into QE with a yield target may face initial credibility issues about its willingness to buy bonds. Hence its resolve may be ‘tested’ quite early.
Liquidity impacts and exit
A key advantage of yield targeting is that it might be more effective than quantity targeting in achieving a particular outcome, in terms of bond yields. But under yield targeting the negative impact on market liquidity might be much greater, with adverse implications for other market participants.
Related to this, yield targeting might also see a much smaller increase in the money supply than a quantity target. This might mean less downward pressure on the currency, offset by the fact that it might be more successful in lowering relative interest rates.
There is also the problem the yield target might act as a floor as much as a ceiling, requiring adjustment of the target, with implications for the credibility of the target. Explicitly communicating the target is a ceiling may diminish this concern; although, if other central banks are aggressively purchasing bonds regardless of the level of yields, then an RBA policy aimed at targeting a yield level may see ACGBs left behind. The recent rally in bonds is a reminder of how quickly markets can move.
A final issue with yield targeting is the problem of exit. While quantity targeting also faces an exit problem, the fact there is no set price for bonds means that tapering is likely to be easier as economic conditions improve. The rise in yields that is likely to take place under such circumstances poses less of a challenge for a quantity target than it does for a yield target.
With a yield target, the RBA could find that if global yields start to rise on signs of economic improvement, it faces a wave of selling that needs soaking up to maintain its target. While strictly speaking the RBA has little constraint on the size of its balance sheet, it (and the Government) may become concerned about the size of the capital loss it could face when the yield target is removed.