US Policy Changes Vol.92 (Quantitative Easing)

(The below excerpt is on our own.)

The Fed’s Yield-Curve-Control Policy (w PDF; 11/29/16) | Owen F. Humpage @ClevelandFed

…some may follow the example of Japan, which recently added a new long-term interest-rate target to its short-term target to give itself “yield-curve control.” …combining yield-curve control with quantitative easing when government borrowing needs are substantial can create constraints on monetary policy that are not easily removed.

… The Bank of Japan currently sets its short-term policy target—a rate paid on bank reserves—at –0.1 percent and now promises to cap its long-term target rate—that on 10-year government bonds—at approximately zero for the time being. …

The ultimate objective of recent quantitative easing programs in Japan, the United States, and elsewhere has been to lower long-term interest rates when policy rates are at their effective lower bound. …

… The Fed’s experience, however, suggests that combining yield-curve control with quantitative easing when government borrowing needs are substantial can create constraints on monetary policy that are not easily removed. Moreover, a central bank’s heavy involvement in a market can distort the behavior of private market participants to the detriment of market efficiency.

Wartime Yield-Curve Control
… The economy had been recovering from the 1937–38 recession, and by late 1941, output had caught up to where it likely would have been had the Great Depression never occurred. Likewise, the unemployment rate fell sharply in 1941, but some slack remained in the labor market at the start of 1942. …

… Gold had generally been flowing into the United States since Franklin D. Roosevelt devalued the dollar in 1934. …commercial banks held record levels of excess reserves in 1940, and the Federal Open Market Committee (FOMC) fretted that reserves “had risen beyond the System’s power to restrain an inflationary credit expansion should one develop” …

Figure 1.

In early 1942, … the Fed agreed to peg the Treasury-bill yield at 0.375 percent, to cap the critical long-term government bond yield at 2.5 percent… Setting interest rates in this manner, however, allowed the Treasury to expand bank reserves by issuing more securities than the public wished to hold when yields reached their caps, because the Fed then had to purchase them. …

…no one really knew if this yield-curve-control policy would work. Treasury Secretary Henry Morgenthau, the only official with authority to announce the program to the public, never did so. He seemed to prefer a quantitative (excess-reserves) target. …

To tamp down measured inflation and inflation expectations, the Roosevelt Administration began introducing limited price controls as early as May 1940… The controls remained in place until November 1946…

… Excess reserves… continued to fall through mid-1944.

Under its yield-curve-control program, the Fed bought $20 billion worth of Treasury securities or approximately 10 percent of the debt that the Treasury issued between March 1942 and August 1945…

Figure 2.

The Accord
…bond holders would liquidate their government securities, forcing the Fed under its yield-curve-control policy to create reserves… By 1945, banks’ holdings of government securities equaled more than half of their total assets, and a substantial proportion of these matured beyond five years…

… The Treasury believed that it could not possibly finance its unprecedented levels of public debt at reasonable interest rates without the Fed’s continued participation in the government-securities market…

… In 1950, an inflation scare associated with the Korean War and growing congressional support for the Fed’s position led to a Treasury–Fed accord in March 1951, largely freeing monetary policy from its subordinate status vis-à-vis the Treasury’s debt-management operations…

Collateral Damage
… Moreover, the FOMC had directed its trading desk to maintain orderly conditions in government securities markets…

Federal Reserve Chairman William McChesney Martin… feared… by creating a “disconcerting degree of uncertainty” about when, how much, and where on the yield curve the Fed might intervene…

Martin believed that the Fed’s frequent interventions in the longer-term government securities market during and immediately after the war had robbed the market of its “depth, breadth, and resiliency,” … Martin wanted to confine open market operations to the short-end of the yield curve—preferably Treasury bills. …

… Many economists observed that the connection between changes in short-term rates and long-term rates—the link “bills preferable” relied on—was generally weak and often not dependable. They contended that open market operations in longer-term securities offered a viable mechanism for affecting the yield curve’s shape, which was as important as the level of interest rates. …

… Nevertheless, the Fed remained wary of the political consequences of appearing to interfere with the Treasury’s debt-financing operations and from 1954 through mid-1975 engaged in “even keel” operations. …

Passé?
… Yield-curve control gave the Treasury substantial influence over monetary policy and highlighted the major effect that monetary policies had on the cost of financing the government’s huge debts.

… The Bank of Japan has greatly expanded its portfolio of government bonds and has become a major factor in the government bond market, much like the Fed in 1945. …