Yield curve control: back to the future

Until very recently, standard central banking practice meant implementing policy objectives solely via overnight interest rates. The rest of the complex network of interest rates was then established by the market.

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But with policy interest rates practically at zero in many places, this thinking is changing. Some central banks - including the Reserve Bank of Australia (RBA) - are now encroaching on those rates previously left to the market.

"The competing desires to save and invest operated on what Keynes called “effective demand” which determined the level of output.”

These initiatives are being called “yield curve control”. They are not new. In fact, it wasn’t too long ago these ideas represented normality or even recommended best practice.

During World War II, the US Federal Reserve and the Bank of England fixed interest rates on both short-term and long-term government debt. The purpose was to give their government fiscal space for the enormous spending needed to sustain the war effort.

Their success allowed these policies to continue after the war. So why were they stopped? And were they a good idea?

In the UK, the idea grew largely from the theories of John Maynard Keynes, a strong supporter of a permanent ‘cheap money’ policy.

For Keynes, interest rates depend on the public’s “liquidity preference”. In times of uncertainty, the public attempts to retreat into liquid instruments such as cash - something not possible for everyone all at once. It’s then the job of higher interest rates to ration liquidity by discouraging the hoarding of cash.

Prior to this – and again now - economists instead held interest rates responsible for balancing investment and saving. Keynes pointed out the fallacy of this view.

“It should be obvious that the rate of interest cannot be a return to saving or waiting as such,” he said. “For if a man hoards his savings in cash, he earns no interest, though he saves just as much as before. On the contrary, the mere definition of the rate of interest tells us in so many words that the rate of interest is the reward for parting with liquidity for a specified period.”

Instead, the competing desires to save and invest operated on what Keynes called “effective demand” which determined the level of output. Too much saving relative to investment causes a slump, the opposite generates inflation pressures.

Central banks, in Keynes’s experience, had the power “to make the long-term rate of interest what they choose within reason”.

Take the power back

However, Keynes’ theories didn’t fly at the Federal Reserve. In 1951 it wrestled monetary policy off the US Treasury, ironically with the intention to maintain only a minimal control of interest rates. Perhaps a rare case of power given up voluntarily?

With Keynes’ death in 1946, the driving force and intellectual power behind ‘cheap money’ was gone and the City of London reasserted itself.

Nevertheless, the worldwide decoupling of money from gold has greatly expanded the money authorities’ room for manoeuvre. As fundamentally conservative institutions, their concern is with perceptions as much as anything. They are reluctant to ignore the rules from the past and test the limits of their interest rate control.

Despite this built-in inertia, the boundaries of their perceived powers are now being challenged.

First, consider the experiments over the last decade: forward guidance, quantitative easing and negative interest rates. These have tested conventional wisdoms and faced down the dogmatic fears of monsters in the uncharted waters of monetary policy.

Second, new thinking is emerging in the fringes of academia which, by considering the technical realities of banking, brings back into vogue many of the ideas cast aside by years of monetarism and wilful ignorance.

The global COVID-19 crisis has prompted calls to rethink many of the aspects of the pre-virus economic structure. Will it happen? Let’s hope so.

James Culham is Director, Institutional Portfolio Management at ANZ

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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