How does yield curve control work?



Many readers had difficulty understanding my recent post on interest rates, exchange rates and monetary shocks. That’s probably because most of us have been brainwashed to think of monetary policy in terms of interest rates.

Suppose that 30-year bond yields are 2%. Then the Fed suddenly announces a plan to peg the 30-year bond yield at 1%. What happens?

The interest parity condition tells us that the 30-year forward exchange rate should appreciate roughly 30% relative to the spot exchange rate (ignoring compounding effects.) That sounds highly contractionary, and indeed it might be highly contractionary.

But what really matters is what happens to the 30-year forward exchange rate in absolute terms. If the spot exchange rate depreciates by more than 30% on the news, then the 30-year forward rate might actually depreciate, even as it appreciates relative to the spot exchange rate. Dornbusch overshooting.

Thus when there is a “yield curve control” announcement, you want to look at the impact on forward exchange rates in absolute terms. If the policy is successful (i.e. expansionary), then the forward exchange rate should depreciate in absolute terms.

Yield curve control is a stupid way to do monetary policy, although it’s conceivable that it’s slightly less stupid than what they are currently doing, which is to let inflation fall below the 2% target during a severe recession.



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