Does Yield Curve Control = Forward Guidance?

Since March the RBA has been actively “controlling” the yield curve effectively pegging the interest rate on bonds up to 3 years maturity, first at 0.25 per cent and since November at the lower rate of 0.1 per cent.

What does this mean for the RBA’s traditional monetary policy tool - the overnight cash rate? So far the cash rate and the interest rate set by YCC have moved in tandem and the RBA has been at pains to point out that they do not expect to increase the cash rate for at least 3 years matching the controlled yield curve.

But expectations are not promises.

If the economy improved faster than expectations, with large increases in employment and inflation, could the RBA increase interest rates within the 3 year window?

Obviously while YCC is pinning down 3 year bonds at the effective lower bound, the current cash rate must also be at the same rate (if not lower). For example, it would not be possible to set the cash rate at 0.5 per cent while keeping the 3 year bond yield at 0.1 per cent - or at least not without truly wild interventions in the bond market.

But what if the RBA plans to lift the cash rate over the course of 2022? If this plan was common knowledge today it would create an enormous arbitrage opportunity. Investors could sell all their 3 year bonds and invest the returns in rolling short-term Treasury bills who’s yield would rise with the cash rate for easy profit. This would force the RBA to buy up a large amount of the medium term bonds in order to keep the yield low as the private market offloads them.

This is why the RBA has been keen to emphasise their expectation that rates will remain on hold for the next couple of years. If financial markets do not expect the cash rate to remain at 0.1 per cent for the next 3 years it would pose problems for YCC’s credibility, potentially forcing the RBA to intervene in the market in even greater numbers.

If the RBA wanted to lift the cash rate in 2022 one of two things would need to happen:

• They would need to surprise financial markets by pre-emptively removing YCC, allowing the yields to jump back up and returning full flexibility to their ability to set the overnight cash rate.

• They would need to increase the interest rate that yield curve is pegged at such that both the cash rate and the 3 year yield is capped at interest rate above the effective lower bound.

Both of these approaches carry substantial risks.

The first approach of abandoning the peg contrary to market expectations risks creating a lot of financial turmoil. It would be similar to Switzerland’s decision to suddenly abandon of its currency peg in 2015 which caused an increase in financial volatility. It may also harm the RBA’s credibility when making future promises.

The second approach of gradually raising interest rates across the yield curve risks a run on the peg. The RBA never contemplates a single rate cut or hike in isolation. Hiking interest rates once, would be a strong signal that more increases are likely to occur. If financial markets believe that interest rates could increase further in the near term, they would start selling their 2024 bonds and investing in rolling short term assets which would offer a higher return.  This would force the RBA to buy up those medium term bonds to maintain the peg, potentially leading to large losses to their balance sheet as interest rates continue to rise (and thus their price declines).

These costs are real, but not insurmountable. But if the RBA did decide to lift interest rates early it would make it much implementing yield curve control in a future downturn much, much harder.

In short yield curve control isn’t the same thing as the ironclad promise of forward guidance[1], but it does make lifting rate very tricky to do. The RBA could lift interest rates in contradiction to the yields it is currently pegging, but it would be quite costly and thus well only be considered a tool of last resort by Martin Place.

[1] Forward guidance in practice often is subject to a lot of exceptions and get-out-of-jail clauses. For example, the Bank of England’s forward guidance had multiple subjective ‘knockout’ conditions relating to inflation forecasts, inflation expectations and financial stability.