Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Steer the Yield Curve Without Rate Hikes
Transcript
- Lucas: Most people think central banks only have one way to influence borrowing costs — raise or lower the policy rate. But there is another tool, one that targets long-term rates directly, without ever touching the short end of the curve. Luna: You're talking about yield curve control. It's been in the headlines more lately, especially with the Bank of Japan tweaking its approach. Lucas: Exactly. Yield curve control, or YCC, is when a central bank sets a target for a specific longer-term government bond yield and then buys or sells bonds to keep that yield at the target. It's different from quantitative easing because QE targets the quantity of bonds purchased, not a specific price. Luna: And the most prominent example is Japan. The Bank of Japan introduced its yield curve control framework back in 2016, committing to keep ten-year Japanese government bond yields around zero percent, with a band of plus or minus ten basis points initially. Lucas: That band has widened over time. By 2025, the BOJ had adjusted that band significantly — it's now plus or minus fifty basis points around zero. But the core idea remains: the central bank stands ready to buy unlimited amounts of ten-year bonds if the yield tries to push above the cap. Luna: Which is a massive commitment. It essentially means the BOJ is monetizing the government's debt at a fixed price — at least for that maturity. Lucas: Right, and that has consequences. On one hand, it keeps long-term borrowing costs low for the government and for corporations whose bonds are priced off the curve. On the other hand, it distorts the signal that bond yields normally send about growth and inflation expectations. Luna: And it creates a dependency. If the BOJ ever signals it might let yields rise, markets test the cap aggressively — we saw that in 2023 and again in early 2025. Lucas: That's the credibility problem. Once you commit to a yield cap, you have to defend it. If markets suspect you'll blink, they'll pile in and force you to buy billions — or swallow a loss of credibility. The BOJ has bought hundreds of billions of dollars worth of bonds to maintain its cap. Luna: So why would any central bank take this on? What's the theoretical advantage over just lowering the policy rate? Lucas: When the policy rate is already at zero or negative, you can't push it lower. YCC lets you target longer-term yields that still have room to fall. It directly lowers borrowing costs for mortgages, corporate bonds, and government debt without changing the overnight rate. The BOJ paired it with a negative policy rate — minus 0.1 percent — for years. Luna: But the Fed and ECB have never formally adopted YCC. The Fed did something close during World War II, pegging long-term Treasury yields at 2.5 percent, but that was a wartime measure. Lucas: Modern central bankers have generally preferred QE over YCC because QE is more flexible. If you're buying a fixed amount each month, you can taper or stop. With YCC, your buying is open-ended — you buy as much as needed to hold the line. That can balloon your balance sheet unpredictably. Luna: And it can trap you. Look at the BOJ — its balance sheet is now more than 130 percent of Japan's GDP. That's enormous. Lucas: It is. But to be fair, Japan has unique circumstances — persistent deflation, low growth, and a government debt to gdp ratio over 250 percent. YCC was designed to keep that system from breaking. And it has worked, in the sense that Japan avoided a debt spiral. Luna: Though at the cost of a massively distorted bond market. Trading in Japanese government bonds has dropped because the BOJ owns so many of them — the market is effectively hollowed out. Lucas: That's the big criticism. Market functioning suffers. When the central bank is the dominant buyer and holder, price discovery weakens. Insurance companies and pension funds struggle to find the yields they need. And eventually, if inflation picks up, the central bank faces a painful choice: let yields rise and break its promise, or keep buying and risk fueling inflation further. Luna: Which is exactly what happened in Japan starting in 2022. Inflation rose above the BOJ's two percent target, and they had to adjust the YCC band twice to relieve pressure. They widened it from ten basis points to fifty. Lucas: And that raising of the band had spillover effects globally. When Japan's yields rise, global investors reallocate — they sell U.S. and European bonds to buy Japanese ones, pushing yields up everywhere. The BOJ's YCC decisions rippled through bond markets from New York to Frankfurt. Luna: So it's not just a domestic tool. It connects the world. Lucas: If walking through the economy with us has made something click — if this episode or any other has given you a framework you use — we'd be grateful if you considered supporting the show. Listener support is what keeps this podcast ad-free and focused on explanation, not promotion. You can find us at buy me a coffee dot com slash fexingo. No pressure ever, just a way to say the show matters to you. Luna: Yeah, it genuinely helps. And we mean it — no perks, no tiers. Just a way to keep this going. Lucas: Now, back to the mechanics. One thing that makes YCC interesting is that the central bank doesn't have to buy bonds forever. It only buys when yields threaten to breach the cap. If yields are below the cap, the central bank can actually let its balance sheet shrink. Luna: That distinguishes it from QE, where the central bank buys a fixed amount regardless of yield levels. Under YCC, buying is conditional. Lucas: Exactly. So in theory, YCC can be less disruptive to the balance sheet if market participants naturally align with the target. But in practice, if the market disagrees with the central bank's view, the buying can be enormous. Luna: The Reserve Bank of Australia tried a form of YCC in 2020, targeting the three-year bond yield at 0.25 percent. They abandoned it in 2021 when the economy recovered and yields rose. That's a rare example of a clean exit. Lucas: Australia's case is instructive because they set a short maturity — three years, not ten. That made the commitment easier to manage and eventually exit. Japan chose ten years, which ties the central bank to a much longer horizon. Luna: And the Fed briefly considered YCC during the pandemic but rejected it. Minutes from 2020 show concern about the difficulty of communicating a yield target and the risk of having to buy unlimited amounts. Lucas: The Fed opted instead for QE with a forward guidance twist — they said they'd keep buying until the recovery was substantial. That gave them flexibility. They never had to defend a specific yield level. Luna: So YCC remains a niche tool — used mainly by central banks that have run out of conventional room, or that face unique structural challenges like Japan. Lucas: But it's a tool that tells us something about the limits of monetary policy. When you're at the zero lower bound and QE isn't enough, YCC is one of the few options left. It's a commitment device — the central bank says, 'I'll do whatever it takes to keep yields here.' And sometimes, that promise alone is enough to stabilize markets. Luna: Until it isn't. And then you have to decide whether to back it up with trillions of yen in bond purchases. Lucas: That's the tension at the heart of yield curve control: it's a powerful signal, but it's only as strong as the central bank's willingness to put its balance sheet on the line. And as Japan has shown, that willingness can be tested repeatedly. Luna: So looking ahead — with many central banks still holding large balance sheets from the pandemic, and with rates possibly staying higher for longer — could YCC ever make a comeback in the US or Europe? Lucas: I think it's unlikely unless we hit another deep recession with rates at zero. But the framework itself isn't dead. It's a reminder that central banks have a broader toolkit than just the policy rate — and that when they reach for those tools, the consequences ripple globally.