Eakinomics: All Eyes on the Fed

The Federal Open Market Committee (FOMC) – the policymaking body of the Federal Reserve (Fed) – begins a meeting today. Heading into the meeting it announced a further loosening of the qualifying criteria for the Main Street Lending Program. I think this is a good move, as my recent Senate testimony makes clear. Nevertheless, I remain mystified as to the continued and obvious absence of this program, with no operational date set, over two months after the CARES Act was signed into law.

The big agenda item, however, as reported by The Wall Street Journal, is that “officials are considering capping Treasury yields for the first time since 1951 to signal their commitment to keeping interest rates low. Policy makers are studying the recent experience of Australia’s central bank, which in March set a target of 0.25% for the country’s three-year bond yield.”

Now, how exactly would the Fed do this? Not by literally issuing an edict on the interest rates on Treasuries; it does not have the legal authority to do that. Instead, it would manipulate supply and demand to ensure that the return stayed below any target. If rates threatened to exceed the cap, the Fed would buy the bonds, lowering the interest rate needed to get people to hold the bonds in supply. (It would do the reverse if it wanted higher interest rates.) In effect, the Fed would “fix” the price of Treasuries of a target maturity.

Now, should the Fed do this? A reflexive answer would be no. Price-fixing is bad and leads to damaging unintended consequences. The Fed, however, already is in the price-fixing business; it manipulates the supply and demand of overnight reserves in order to hit its target for the federal funds rate. This change would simply extend the Fed targets to hitting the overnight interest rate and a longer rate on the yield curve.

But interest rates on 3-year (or 5-year, or 10-year) Treasuries would only rise if markets expected future federal funds rates to be higher. That would happen only if the economic conditions improved enough to merit higher rates – please throw me in that briar patch – or if the market is anticipating a Fed policy error. Since it has already pledged to keep rates low for as long as necessary, that should not be a consideration.

So, in the end, moving to controlling longer yields would be an attempt to have them be lower than future circumstances dictate in order to stimulate demand now. That strikes me as a risky move. Getting too cute with financial markets doesn’t make sense when there are other ways to support demand – more fiscal policy or getting the Main Street Lending Program running, for example.