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Fed weighs using yield curve caps to reinforce intention to keep rates low

With few expecting a quick rebound for the U.S. economy, the Federal Reserve is set to discuss new ways to hammer home to markets that it is committed to keeping interest rates low for the foreseeable future.

That includes consideration of an approach the Fed last adopted during World War II: yield curve control. The discussions are still at an early stage, and whether the Fed will end up setting a cap on some portion of the Treasury yield curve is unclear. But top Fed officials have said they are reviewing the potential benefits of yield curve caps, a move that analysts say would help emphasize to the public that low rates are here to stay.

Under the policy, the Fed would set a cap on the interest rate for Treasury securities of a certain maturity, such as a 2-year or 3-year Treasury note, and commit to buying any amount of securities needed to keep rates below the cap. The goal: to ensure bond markets do not nudge up interest rates and make borrowing more expensive for households and businesses, which would dampen spending and delay any bounce-back in economic growth.

"[Yield curve control] will help to reinforce low rates even after the recovery takes shape, preventing market participants from prematurely pricing in hikes," Bank of America analysts Mark Cabana and Michelle Meyer wrote in a research note, though they noted the policy switch is not likely until at least September.

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The U.S. received somewhat positive news on the recovery in the June 5 jobs report, which showed that employers added 2.5 million jobs in May and the unemployment rate dropped to 13.3% from 14.7%. But the jobless rate is still at its highest levels since the Great Depression, and many economists expect a long slog ahead for the job market to return to pre-coronavirus levels.

The rate-setting Federal Open Market Committee may note the surprising jobs numbers in its June 10 statement, but the figures will do little to change the FOMC's strategy of promising to continue to do what it can to ensure a quick recovery, analysts say. The FOMC's June meeting will likely also feature a new round of forecasts from Fed officials, who are expected to show widespread agreement to keep their benchmark federal funds rate at a target range of 0% to 0.25% in 2021 and likely 2022, though a few may pencil in a rate hike that year.

"The market is obviously rallying a lot on [the jobs report] and a view that this improvement is going to be extended over the next few months," said Matthew Luzzetti, chief U.S. economist at Deutsche Bank, in an interview after the jobs report. "I think the Fed will be more cautious in that assessment, particularly given how far away we are from full employment and how much inflation has actually fallen in recent months."

Fed officials have already begun debating ways to clarify their guidance on how long the FOMC will keep the federal funds rate near 0%. 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.

At its April meeting, the Fed discussed whether to make its "forward guidance" more explicit by either promising to keep rates flat for a specific amount of time or until the economy meets certain thresholds. For example, the Fed could pledge to keep rates unchanged until the jobless rate or inflation return to a certain level.

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A few Fed officials suggested in April that yield curve caps on short-to-medium-term Treasurys may help "reinforce" any forward guidance the Fed offers, according to minutes of the meeting. The central bank is "thinking very hard" about the issue and evaluating how yield curve caps have worked elsewhere, New York Fed President John Williams said in a May 27 Bloomberg Television interview.

If the Fed does opt for yield curve caps, analysts expect it to resemble the approach from the Reserve Bank of Australia, which in March set a target of about 0.25% for its government's three-year bonds. The central bank made an initial A$50 billion in bond purchases but has not needed to go further, an indication that yield curve caps and promising to buy unlimited amounts of a certain security could lead to fewer purchases overall.

"The Fed believes it is credible enough that its words alone might be enough to convince the market to trade at or below the ceiling, thereby reducing the amount that must be bought to enforce the cap," former Fed Governor Larry Meyer, who is now president of the research firm Monetary Policy Analytics, wrote in a note to clients, noting that a smaller Fed balance sheet would reduce any political blow-back from Capitol Hill.

The Fed has signaled it would prefer focusing on the shorter end of the Treasury yield curve instead of capping longer-term securities, as the Bank of Japan has done since 2016 by setting a target of around 0% for 10-year yields.

Many Fed officials raised concerns about capping longer-term yields in October 2019, when the central bank discussed the issue as part of its broad review of its monetary policy tools. The yield on 10-year U.S. Treasurys heavily influences other borrowing rates, such as those on 30-year mortgages. But many Fed officials believe capping longer-term yields may be more complicated and that focusing on the shorter end of the curve would better complement its forward guidance on keeping short-term rates low, minutes of the October 2019 meeting show.

Short-term yield caps have one added benefit, analysts say. They would keep those rates contained amid a deluge of short-term Treasury bills that the federal government will continue to issue to help pay for its coronavirus relief efforts. The increased supply of Treasury bills will lower their prices and therefore raise their yields, a development the Fed could keep in check by capping short-term yields.

Fed officials may also choose to pair short-term yield curve caps with a separate effort to buy longer-term Treasurys and keep their rates low. The latter move would be similar to the quantitative easing purchases the central bank made after the 2007-09 financial crisis and would not involve the Fed setting a hard ceiling on long-term yields.

The Fed's Treasury purchases this year, which are primarily aimed at smoothing out earlier disruptions in the Treasury market, have helped its balance sheet rise to a record $7.2 trillion so far. That is significantly above the $4.5 trillion peak the Fed's balance sheet reached after the last crisis. The central bank has dialed back its purchases as conditions have normalized, but it may soon need to undertake more traditional QE purchases, with the explicit purpose of keeping long-term rates low rather than only stabilizing markets.

"They would not want to allow the front end of the curve to be pinned but allow, let's say, 10-year yields to spike up," Deutsche Bank's Luzzetti said. "That would be ... a tightening of financial conditions that would run counter to what they intend to do."

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