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Fed officials question necessity of yield curve caps, worry over more outbreaks

Federal Reserve officials have "many questions" about whether capping parts of the yield curve is necessary in the U.S., but agree that they need to study the issue further, minutes of the central bank's June 9-10 meeting showed.

The minutes also revealed that a number of Fed officials worried three weeks ago about the potential for new coronavirus case outbreaks in the U.S. as states started to reopen their economies, a trend that appears to be playing out amid the recent resurgence of cases.

That risk is one of several that adds an "extraordinary amount of uncertainty" to the future path of the U.S. economy, which may yet see another period of reduced economic activity if fiscal support does not prove to be enough, the FOMC minutes indicated.

Fed officials agreed the actions they have taken this year, including slashing their benchmark interest rate to near-zero levels and launching several emergency lending facilities, have helped reduce risks to the economic outlook. They also noted the "surprisingly positive news" that employers added 2.5 million jobs in May, but they believed a full recovery "would take some time" and that another downturn cannot be ruled out.

"Taken together, the data suggested that April could turn out to be the trough of the recession, but participants agreed that it was too early to draw any firm conclusions," the minutes of the Federal Open Market Committee said.

Much of the June FOMC meeting was spent debating how the Fed could best communicate its intention to keep rates near zero for the foreseeable future — and whether the FOMC should adopt new measures of doing so.

One option the Fed has been weighing is yield curve targeting, where the central bank would set a cap on yields of a certain portion of the Treasury yield curve and commit to buying any amount of Treasurys needed to keep rates below that cap.

Fed officials received a briefing from staff on three routes it could take. One centered on the U.S. experience during and shortly after World War II, where the Fed capped interest rates across the curve. More recently, the Bank of Japan introduced a cap on its 10-year yield in 2016, while the Reserve Bank of Australia began capping three-year yields in March.

The FOMC minutes indicated that the Fed might focus on the short-to-medium end of the yield curve should it pursue a targeting regime, as Fed officials "generally saw the Australian experience as most relevant for current circumstances" in the U.S.

It is far from certain whether the Fed will choose to adopt yield curve caps. Many Fed officials said their current promise to keep the benchmark rate near zero for some time has been heeded by bond markets, and as long as that forward guidance "remained credible on its own, it was not clear" that yield curve caps to reinforce a low-rate policy were necessary.

Nearly all Fed participants said they "had many questions" about the costs and benefits of adopting yield curve caps, though they all agreed to keep reviewing the issue.

They also agreed that the current approach of providing aggressive forward guidance on low interest rates was effective after the 2007-09 financial crisis and will continue to be a critical element of the Fed's monetary policy toolkit. But officials continued to debate ways to make that guidance more clear.

Right now, the Fed statement indicates it will keep rates unchanged until officials are "confident that the economy has weathered recent events" and is on track to meet the Fed's goals of maximum employment and 2% inflation. But multiple Fed officials said the Fed should provide greater clarity about its interest rate policy and its ongoing purchases of Treasurys and mortgage-backed securities.

Fed officials generally agreed that "outcome-based forward guidance" was a good idea, but they were split on what outcomes they should target. A number of Fed officials favored providing policy guidance based on inflation outcomes and a possible overshoot of the Fed's 2% target. A couple of other Fed officials preferred tying forward guidance to progress on the U.S. unemployment rate, which they said would "clearly signal a high degree of accommodation for an extended period."

A few at the Fed also said calendar-based forward guidance, where the Fed lays out a date it is targeting to begin tapping the brakes on accommodation, might "be at least as effective as" an outcomes-based approach.

But a couple of Fed officials worried that committing the Fed to "maintaining very low interest rates for a long time could ultimately pose significant risks to financial stability."