Fed officials are likely to debate how to clarify their asset-purchase plans at their meeting this week.
Photo: kevin lamarque/ReutersTo stimulate the economy in the past decade with interest rates pinned near zero, the Federal Reserve made promises about how long they would remain low.
Now, Fed officials are thinking hard about a new tool that would reinforce such promises by committing to buy Treasury securities in whatever amounts are needed to peg certain yields at low levels.
Fed officials aren’t prepared to announce any decision on so-called yield caps when their two-day policy meeting concludes Wednesday.
With rates near zero and unlikely to go lower, two other policy questions must get resolved first: how to manage their pace of bond purchases and how to communicate their long-run intentions, using so-called forward guidance.
Fed officials believe forward guidance helps stimulate demand after their policy rate is near zero because it sets public expectations about future policy, which influences the rates set by markets.
How they calibrate those two tools could determine whether and how they cap yields, which would function as a hybrid of both. The Fed hasn’t capped yields on Treasury securities since 1951, when it dismantled a stimulus scheme used during World War II.
Fed officials are closely studying the experience of Australia’s central bank, which in March set a target of 0.25% for the country’s three-year government-bond yield and which has so far managed to keep it there without significant asset buying.
For the U.S., caps might work like this: If the Fed concludes it is likely to hold rates near zero for at least three years, it could amplify this commitment by capping yields on every Treasury security that matures before June 2023.
While some officials don’t think caps are needed now because investors don’t expect the Fed to lift short-term rates for several years, caps could limit any unwelcome jump in Treasury yields due, for example, to a coming surge of government-debt issuance to finance virus-related economic relief.
Reinforcing forward guidance with caps could also push back against the strong pressure to raise rates that officials faced last decade amid fears of an inflation upturn that never materialized, said Fed governor Lael Brainard in a speech last fall.
First, officials will have to design their forward guidance and consider their asset-purchase goals. Forward guidance comes in two flavors: One ties changes in rates to meeting certain economic thresholds, while the other links them to certain calendar dates in the future. In the first case, for example, the Fed could say it won’t raise rates until inflation reaches 2% and unemployment falls to 5%. In the second, it could say it will hold rates steady for at least two years.
Tying guidance to economic thresholds might better address the uncertainty surrounding the outlook, while calendar-based guidance provides more certainty to investors and could be more effective at keeping rates low when data turn around decisively, said Roberto Perli, a former Fed economist who is now at Cornerstone Macro.
Yield caps would be a natural complement to the calendar-based guidance but could be trickier to communicate if paired with outcome-based guidance.
Capping yields brings risks. Because investors already expect rates to stay low, the tool may not provide much stimulus unless the Fed were prepared to target longer-dated Treasurys. Prematurely ending the caps, either because of inflation or financial-stability concerns, would damage the Fed’s credibility and could lead to a nasty rise in rates. Setting caps at a level investors deem too low could force the Fed to buy massive amounts of securities to defend its peg.
“It’s easy going in, but we don’t really understand how the exit is actually going to work,” said William Dudley, who was president of the New York Fed from 2009 to 2018.
At this week’s meeting, Fed officials are likely to debate how to clarify their asset-purchase plans. The Fed extinguished a financial panic in mid-March by purchasing huge quantities of Treasurys and mortgage bonds after investors dumped long-dated securities in a flight for cash. The Fed has been gradually reducing purchases every week.
Officials have said their purchases, totaling more than $2.2 trillion since mid-March, are designed to restore orderly market function. This rationale is different from their prior open-ended round of asset purchases, called quantitative easing or QE, conducted between 2012 and 2014, which was designed to stimulate hiring and investment and was more concentrated at longer-dated securities than the current purchases have been.
Finally, officials face questions about when to roll out any policy shift. Recessions have typically been caused by a sharp rise in oil prices or economic and financial imbalances that trigger an abrupt increase in interest rates. The Fed cuts interest rates to stimulate growth during and after a downturn.
The current downturn is different. The economy is facing a cash-flow problem, not just a drop-off in demand, and a potential wave of bankruptcies looms. Because it may take time to safely restore economic activity given the threat of infection, what ails the economy can’t be solved solely by boosting demand.
Economists have warned that while financial markets are functioning better amid recent Fed actions, the lifting of lockdown orders could reveal more economic damage than expected.
Analysts at Bank of America think the Fed will implement forward guidance and yield caps in September, “once the bounce from reopening passes and it becomes clear that the recovery will be protracted and challenging,” said Mark Cabana, the bank’s head of interest-rate strategy.
Declining inflation would mean that short-term interest rates, adjusted for inflation, could rise, posing a challenge for Fed policy makers as they seek to provide more stimulus in the coming months.
By the fall, Mr. Cabana expects inflation will be running very low, and the Fed will want to push expectations of future inflation higher by sending a strong signal that rates will be held near zero until 2023 if not longer.
Write to Nick Timiraos at nick.timiraos@wsj.com
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