Mon. Dec 6th, 2021

The Reserve Bank of Australia’s chaotic exit from yield curve control last week, after markets cracked through its limit on three-year bond yields, illustrates the growing pressure on central banks to tighten monetary policy as the pandemic’s global economy recovers.

But it also exposed a serious problem with the whole yield curve control policy: unlike asset purchases, which can be easily reduced when the economy improves, it is very difficult to get a smooth exit from a bond yield restriction. make.

This means the episode has important lessons for other central banks, such as the Bank of Japan, which either used yield curve control or considered the policy.

“If we put all the experience together, it is quite unlikely that we will have a return target again,” he said. RBA Governor Philip Lowe. “And it’s not just because of last week’s experience.”

Under yield curve control, the RBA last year promised to buy as many three-year bonds as needed to keep their yields at 0.1 percent, the same as its overnight rate. The Bank of Japan set a target for 10-year bond yields in 2016 and that policy continues.

The purpose of yield curve control is to stimulate the economy when short-term interest rates are already at zero. The target of three-year yields made sense in Australia, analysts said, as most loans were either variable rates or had terms of less than five years.

Initially, it was easy for the RBA to keep yields on target because the economy was weak and markets expected rates to remain low. But it never formally committed to stopping overnight rates for three years. Instead, it said it was his “central scenario”.

“This meant that if markets thought that the economy would perform significantly better than this central scenario, and push yields higher, the RBA would be forced to intervene heavily in the bond market or drop the pen,” says Isaac Gross , a former RBA economist who now teaches economics at Monash University.

“Whenever the RBA faced this dilemma, the RBA would always choose the latter as the least bad option,” he said. Improved Australian economic data and the recent rise in global bond yields meant that the 0.1 per cent yield on April 2024 bonds started to look too low. The market began to question the RBA’s predictions and forced it properly to drop the pen.

Line chart of government bond yields (%) stabilizing Australian yield curve after RBA shock

One major problem the RBA had with yield curve control was that, in Australia, the large, highly liquid futures market drives the cash bond market and not the other way around. It finally solved that problem in July by keeping the April 2024 bond as the target when it fell out of the futures basket, rather than moving to the November 2024 bond. But it chose to keep the cap.

“The RBA should have ended yield curve control in July 2021 rather than linking the target to the April 2024 effect,” said Gareth Aird, head of Australian economics at Commonwealth Bank. Aird proposed as early as November last year that the target should be dropped.

Determination on April 2024 created the impression that the RBA policy has a time-based expiration date rather than being linked to economic conditions. The RBA realized the contradiction, but an improved outlook – the central bank now expects growth of 5.5 percent next year – has meant that markets have already begun to challenge its leadership not to raise overnight rates before 2024.

“The Delta variant simply delayed the inevitable. “It would have been a better policy to leave proactively before markets forced the RBA’s hand,” Aird said.

With no precedent for an exit from yield curve control, the RBA struggled to communicate its plan. At one point, the central bank was so convinced of its predictions that it planned to continue with the target until the April 2024 bond expired.

Eventually, the lack of a clear exit plan led to the sudden unraveling, as markets pushed returns through the shell. What was once touted as a successful innovation ended with the RBA losing some credibility.

Gross said: “Any future decision to launch a new program should carefully consider what future commitment it will entail and what its potential exit strategies will be – including the potential cost of abandoning the strategy suddenly.”

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