Australia’s disorderly exit exposes yield curve control deficiencies
After the market broke the upper limit of the three-year bond yield, the Reserve Bank of Australia turbulently withdrew from yield curve control last week, indicating that as the world economy recovers from the pandemic, the central bank is under increasing pressure to tighten monetary policy.
But this also exposes a serious problem with the entire yield curve control policy: Unlike asset purchases that are easy to gradually shrink as the economy improves, the upper limit of bond yields is difficult to withdraw smoothly.
This means that this incident has important lessons for other central banks such as the Bank of Japan, who have either used yield curve control or considered the policy.
“Combining all the experience, we are unlikely to set the rate of return target again,” Philip Lowe, Governor of the Bank of Australia“It’s not just because of the experience last week.”
Under the control of the yield curve, the Bank of Australia last year committed to buying as many three-year bonds as possible to keep its yield at 0.1%, the same as the overnight interest rate. The Bank of Japan introduced a 10-year bond yield target in 2016, and this policy is still continuing.
The purpose of yield curve control is to stimulate the economy when short-term interest rates are already zero. Analysts say it makes sense to target a three-year yield in Australia because most loans are either with floating interest rates or with maturities of less than five years.
Initially, it was easy Reserve Bank of Australia As the economy is weak and the market expects interest rates to remain low, the yield is kept at the target level. But it never officially promised to keep overnight interest rates unchanged for three years. Instead, it says this is its “core scenario.”
“This means that if the market believes that the economy will perform significantly better than this central scenario and push up yields, then the Bank of Australia will be forced to intervene in the bond market or abandon its pegging policy,” the current former economist of the Bank of Australia Isaac Gross said. He teaches economics at Monash University.
“When faced with this dilemma, the Reserve Bank of Australia will always choose the latter as the worst option,” he said. The improvement in Australian economic data and the recent rise in global bond yields means that the 0.1% bond yield in April 2024 is beginning to look too low. The market began to question the Reserve Bank of Australia’s forecast and forced it to abandon its peg to the exchange rate in due course.
One of the big problems encountered by the Bank of Australia in terms of yield curve control is that in Australia, the large, highly liquid futures market promotes the cash bond market, not the other way around. It finally solved the problem in July, making April 2024 bonds as a goal to withdraw from the futures basket instead of turning to November 2024 bonds. But it chose to keep the upper limit.
“The Bank of Australia was supposed to end yield curve control in July 2021, instead of linking the target to April 2024 bonds,” said Gareth Aird, head of Australian economics at Commonwealth Bank. Aird had suggested abandoning this goal as early as November last year.
The April 2024 amendment gives the impression that the RBA policy has a time-based expiration date, rather than being tied to economic conditions. The Bank of Australia is aware of this inconsistency, but the improved outlook — the central bank now expects to grow by 5.5% next year — means that the market has begun to challenge its guidance not to raise overnight interest rates by 2024.
“The Delta version just delays the inevitable. It would be a better policy to take the initiative to withdraw before the market forces the Reserve Bank of Australia to take action,” Aird said.
As there is no precedent for exiting yield curve control, the Bank of Australia has worked hard to communicate its plan. Once, the central bank believed its forecast so much that it planned to continue to achieve this goal before the bond maturity in April 2024.
In the end, when the market pushed the rate of return above the upper limit, the lack of a clear exit plan led to a sudden ending. The innovation that was once touted as a success ended in the RBA losing some of its credibility.
Gross said: “Any future decisions to introduce a new plan should carefully consider what future commitments this will involve and what its potential exit strategy is-including the potential cost of having to abandon the strategy suddenly.”