Improving conventional unconventional policy

The Fed has taken the position that the distressing signals from around the world do not clearly warrant a large and definitive downward shift in the outlook for the U.S. While some folks might argue that point, let’s accept it. There is, nonetheless, a heightened probability of some sort of downturn, and policymakers and others are considering what responses to that dark outcome are available. The metaphors are not pretty: Is the cupboard bare? The ammunition chest empty? With some central banks around the world targeting negative nominal interest rates, analysts are questioning whether that particular ammunition is more likely to blow up in our faces than to hit the target.

From the U.S. perspective, we think the debate is missing a key element: policy options in the U.S. look substantially different from those in the euro area or Japan. Specifically, the 5-year Treasury yield in the U.S. is now about 120 basis points, while these yields are negative for Japan and Germany. The U.S. 10-year yield is near 175 basis points, while those yields for the other two nations are near zero. The U.S. has room for more than 100 basis points of accommodation in longer-term yields that is not available elsewhere.

Pushing longer-term rates down using asset purchases has, over the past 8 years, become the conventional form of unconventional policy. And, while debates continue about how much stimulus comes from such policies, most reasonable estimates suggest that the effect is modest, but positive. (The magnitude and sign of the net effect of negative rates is less clear.)

Moreover, if times become truly desperate, the Fed could opt to employ what is likely to be an even more potent form of conventional unconventional policy: directly capping some longer-term yields.

As Ben Bernanke explained before the crisis and the FOMC discussed at length in October 2010,[1] central banks could cap, say, 5-year or 10-year yields by announcing a willingness to purchase whatever it takes to enforce the cap.[2]

Up to now the Fed has chosen instead to manage asset purchases by announcing a given monthly quantity of purchases and then adjusting that rate of purchases, if needed, to attain the desired effect. The FOMC’s 2010 discussion shows that this choice was viewed as prudent at a time when very little was known about asset purchases and when the goal was to accelerate an ongoing recovery. Targeting yields was viewed as potentially more effective but also risker, something, as Gov. Yellen said at the time, to “hold in reserve if further stimulus proves necessary.”[3]

We all understand purchases a good deal better today. And should the FOMC have to contemplate responding to a downturn, the cost/benefit analysis on capping longer-term yields arguably looks much more favorable than it did in 2010.

Moreover, despite some risks, the FOMC analysis argued that targeting longer-term yields is quite likely to achieve a given move in longer-term rates with substantially smaller purchases of treasury securities than would be needed using the quantity-based approach. We’ve seen this in action: soon after Mario Draghi pledged to ‘do whatever it takes’ to resuscitate Italian and Spanish treasury markets, both markets registered impressive recoveries, notwithstanding the fact that the ECB did not—and could not at that moment—implement any outright monetary transactions.

While we can argue over the explanation for Draghi’s success, there is a fairly straightforward reason why targeting yields might minimize the purchase quantity required to achieve a desired effect. Under the quantity approach, the Fed has emphasized that it is the entire expected path of future purchases that will determine the effect on longer-term yields today. Perhaps unsurprisingly, it’s proven hard to communicate unambiguously about that future path of purchases. A simpler statement is implied under the yield-based approach: we’ll buy whatever it takes to cap the current 5-year yield at, say, 90 basis points. Imprecise statements about contingent plans for future purchases are replaced by concrete statements the market yield.[4]

Back to the more general point: a recession at the current time would be extremely worrisome. The U.S. fiscal authorities seem likely to be hamstrung,[5] and with the policy interest rate near zero, the Fed would be forced to respond using unconventional tools. But at least the U.S. has considerable space to use conventional unconventional policy—pushing down longer-term yields using asset purchases. And the ammunition chest contains a potentially powerful tool for doing this that has so far been held in reserve: capping certain longer-term yields.


1. The FOMC held conference call on related topics on Oct. 15, 2010. This discussion is based on the transcript of the call and a supporting memo. [back]

2. There is no doubt that a credible promise, backed up by action, could enforce the cap. If you offer to buy unlimited quantities at a given high price (that is, a given low yield), nobody will sell at a lower price. [back]

3. FOMC Transcript, Oct. 15 2010. [back]

4. Of course, the FOMC would presumably still face challenges communicating about the future path of longer-term yields. But this is very different from the quantity-based approach in which implications for current longer-term yields are left vague. [back]

5. Actually, as the questioning at Chair Yellen’s recent testimony reveals, some in Congress are very keen to re-enact the Congress’s 1937 tragic tightening fiscal policy. [back]