Yield curve control (YCC), also known as interest rate pegs, is a monetary policy strategy where a central bank sets bond yields. This approach is classified as unconventional monetary policy.

In YCC, a central bank targets a specific interest rate for a particular maturity and purchases the necessary amount of government debt securities to achieve that target. The central bank announces that it will not permit interest rates within a certain segment of the yield curve to exceed a specified level. For instance, the Federal Reserve might declare a target rate of 50 basis points (0.50%) and indicate its readiness to buy all Treasury bonds of a certain maturity that trade above this rate.

The central bank aims to convey that it will purchase as many bonds as needed to prevent borrowing costs from rising. This clear communication helps businesses and households plan their finances effectively. Essentially, YCC involves "pegging" or "anchoring" government bond yields at a predetermined level, theoretically allowing control over the yield curve's shape, which reflects the difference between short-term and long-term bond yields.

Implementing YCC could lead to increased stability in interest rates and reduced volatility, but it may also pose risks, such as a significant expansion of the central bank's balance sheet. As a monetary policy tool, YCC serves as an alternative to quantitative easing (QE), which has been utilized extensively over the past decade. While QE employs newly created electronic money to broadly purchase government bonds and other assets, YCC specifically manages interest rates through targeted asset purchases and sales.

In typical economic conditions, the Federal Reserve (Fed) influences the economy by adjusting very short-term interest rates, such as the rate banks earn on overnight deposits. Under YCC, the Fed would target a specific interest rate level and be prepared to buy Treasuries to prevent the rate from exceeding its target. This could be a method for the Fed to stimulate the economy if lowering short-term rates to zero proves insufficient.

YCC differs from QE in a significant way: QE focuses on the quantity of bonds, while YCC emphasizes the prices of bonds. For example, if the Fed announces it will buy $1 trillion in Treasury securities, this increases demand, raising prices. Since bond prices and yields are inversely related, higher prices lead to lower interest rates (lower yields), which is characteristic of QE.

In contrast, under YCC, the central bank commits to purchasing whatever amount of bonds the market offers at its target price. In the previous QE example, the Fed aimed to buy $1 trillion worth of securities. However, in YCC, there is no specific dollar amount targeted; the Fed will continue buying until it reaches the desired price. Once the bond market recognizes the central bank's commitment, the target price effectively becomes the market price, as sellers would prefer to sell to the Fed rather than to private investors for less.

To illustrate, consider an iPhone that costs $1,000 and pays $10 annually for two years, yielding 1%. If the Fed wants to maintain the iPhone's price at $1,000, but demand drops, sellers may lower the price to $800, raising the yield to 1.25%. The Fed would then step in to buy iPhones until the price returns to $1,000, demonstrating YCC. Replace the iPhone with a 2-year bond with a 1% yield, and you have a real-world example.

YCC is not a new concept. The Bank of Japan (BoJ) is the only major central bank to have implemented interest rate pegs in recent history. In 2016, with short-term rates already negative, the BoJ launched an experiment to anchor yields on 10-year Japanese Government Bonds (JGBs) near zero percent to combat low inflation and stimulate consumer spending.

When private investors are unwilling to pay the target price, the BoJ purchases more bonds to keep yields within the desired range. YCC is part of the BoJ's broader policy strategy, which includes quantitative easing, forward guidance, and negative interest rates, all aimed at increasing inflation. The BoJ has largely succeeded in maintaining the zero percent yield on JGBs and has reduced bond purchases compared to its previous QE program.

Theoretically, interest rate pegs should influence financial conditions and the economy similarly to traditional monetary policy. Lower interest rates on Treasury securities can lead to:

• Lower interest rates on mortgages, car loans, and corporate debt
• Higher real estate prices
• Higher stock prices
• A weaker dollar

These changes can encourage consumer and business spending and investment.

Recent research indicates that maintaining medium-term rates at a low level after the federal funds rate hits zero could expedite economic recovery following a recession. However, the effectiveness of this transmission from pegged yields to private-sector interest rates largely depends on the Fed's ability to convince financial markets of its commitment to the program.

For instance, if the Fed announces a peg on 1-year Treasury securities at zero percent, investors will trade those securities at a price consistent with the peg if they believe the Fed will adhere to the program for the entire duration. In this case, the Fed may need to purchase only a limited number of bonds to maintain prices at the target, leading to lower interest rates without significantly expanding its balance sheet.

If investors doubt the Fed's ability to maintain the peg, they may be reluctant to buy 1-year bonds at the Fed's price, forcing the Fed to purchase large quantities of the pegged securities. An abrupt spike in yields could compel the central bank to buy Treasuries extensively. In July 2018, the BoJ had to offer to buy unlimited amounts of bonds at 0.11% to prevent long-term rates from exceeding the target as global yields rose.

While historical examples of YCC focus on long-term rates, U.S. policymakers have indicated that if the Fed were to adopt an interest rate peg, it would likely target near or medium-term rates. This is because the Fed primarily uses the overnight borrowing rate as its main policy tool, meaning any balance-sheet-related policy must align with its expectations for the overnight rate.

Targeting long-term yields, such as the 10-year Treasury, would likely necessitate a significant expansion of the balance sheet. Maintaining such a strategy would require investor confidence in low inflation and short-term rates throughout the peg's duration. In the U.S., targeting shorter-term yields would be more feasible and likely perceived as credible compared to targeting long-term yields.

One reason for the success of the BoJ's target on JGBs is that many private investors adopt a "buy and hold" strategy rather than trading them. Large institutions that prefer or are required to hold safe government bonds are willing to retain JGBs even if they anticipate rising short-term rates before maturity. Additionally, the BoJ's substantial presence in the JGB market, holding nearly 50% of it, enhances the effectiveness of YCC in Japan.

In contrast, the U.S. Treasury market is the largest and most liquid globally, with the Fed holding less than 20% of the market. Investors in the U.S. frequently trade bonds as they adjust their rate expectations, making them less likely to adopt a "buy and hold" approach.

Like other unconventional monetary policies, YCC carries significant risks, particularly regarding the central bank's credibility. It requires a commitment to maintaining low interest rates over a future timeline, which can encourage spending and investment but also risks allowing inflation to rise too quickly while adhering to the commitment.

For example, if the Fed commits to a 3-year peg, it must rely on the assumption that inflation will not exceed its 2 percent target during that period. If inflation does rise, the Fed may face the dilemma of either abandoning the peg or failing to meet its inflation objective, both of which could damage its credibility.

Some risks associated with QE also apply to YCC. Both policies may necessitate significant asset additions to the Fed's balance sheet. While the Fed's experience with QE suggests minimal side effects from balance sheet expansion, it has expressed a preference for a smaller balance sheet for various reasons. However, YCC could potentially require less balance sheet expansion than QE, assuming the peg is credible and focuses on medium-term assets, making it appealing to policymakers.

Explicitly targeting yields may also present political challenges, raising concerns about central bank overreach and market intervention. In summary, if the central bank can implement a YCC policy smoothly and credibly, it can serve as an effective tool to support the economy when traditional monetary policy is constrained by the zero lower bound (ZLB), which occurs when short-term nominal interest rates are at or near zero, creating a liquidity trap and limiting the central bank's ability to stimulate economic growth.

Researchers suggest that YCC would be more effective when combined with forward guidance and QE, both of which are already part of the Fed's toolkit. Forward guidance and a zero-rate peg on near-term securities reinforce each other by signaling to markets that low rates are expected for an extended period. Meanwhile, QE could exert downward pressure on longer-dated assets than those subject to the peg.

In other words, when used together, these three unconventional monetary policies could simultaneously lower, flatten, and stabilize the entire yield curve while maintaining its structure as much as possible.