Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use the Yield Curve as a Policy Tool
Transcript
- Lucas: So you've heard the phrase 'inverted yield curve' roughly a million times in the last few years, usually as a recession warning. But here's the thing: central banks don't just read the yield curve — they actively shape it. And since the financial crisis, shaping the curve has become one of their primary tools. Luna: And we're not talking about just setting the short-term policy rate, right? I mean, that's the classic lever. Lucas: Exactly. The old model was simple: the Fed sets the federal funds rate — that's the very short end — and then let market forces determine longer-term rates. But that changed when the short rate hit zero in 2008 and the Fed needed more firepower. Suddenly, they started buying long-term Treasuries directly to push down yields across the curve. Luna: Which is quantitative easing, but people forget that QE was specifically designed to flatten the yield curve. The Fed bought long bonds, which drove their prices up and yields down. Lucas: Right, and that's the mechanism. When the central bank buys long-term government bonds, it reduces the supply available to private investors, which raises bond prices and lowers yields. That pulls down borrowing costs for mortgages, corporate bonds — everything tied to longer-term rates. And here's where it gets interesting: the Fed has also used a tool called Operation Twist, where they sell short-term securities and buy long-term ones. That flattens the curve without expanding the balance sheet. Luna: Operation Twist — I remember that from 2011. It was basically a swap: shorten the supply of long bonds while lengthening the supply of short bills, right? Lucas: Exactly. And it's actually a really elegant signal. By doing that, the Fed is saying: we're keeping short rates low for a while, and we're actively containing long-term borrowing costs. It's a way to ease financial conditions even when the policy rate is already at zero. Luna: And if walking through the economy with us has made something click for you, it'd be great if you'd consider supporting the show. We keep it ad-free, and listener support at buy me a coffee dot com slash fexingo really helps keep that going. Lucas: Yeah, absolutely. No pressure, but if you've found these episodes useful, that's the best way to keep them coming. Now — back to the curve. One of the most extreme examples of central bank yield curve management is the Bank of Japan. Luna: Yield curve control. They set a target for the 10-year Japanese government bond yield, and they buy or sell as many bonds as needed to keep it there. It's been running since 2016. Lucas: And it's a fascinating case study because it shows the limits of the approach. The BOJ set their 10-year target at around zero percent, but by 2022, inflation was picking up globally, and market forces wanted higher yields. The BOJ had to buy enormous amounts of bonds to defend that ceiling. At one point, they were buying more than the entire new issuance of Japanese government bonds. Luna: So they basically owned the entire market for new bonds. That's not a signal anymore — that's a price control. Lucas: Right. And in 2024 and 2025, they gradually loosened the ceiling, letting the 10-year yield drift up to around 0.5 percent then 1 percent. But the key lesson is: you can override market pricing in the short run, but the longer you do it, the more distortions you create — especially if inflation expectations move against you. Luna: So how does the Fed think about the yield curve now, in mid-2026? We're still in a relatively high-rate environment, and the curve has been inverted for a while. Lucas: That inversion is a market signal, not a Fed tool. The Fed sets the short end high — the fed funds rate is still elevated — and the market expects rates to come down eventually, so long-term yields are lower. That's what an inversion is. But the Fed also cares about the term premium — the extra compensation investors demand for holding long-term bonds over rolling short-term ones. Luna: And the term premium has been weird lately. It was negative for years during QE because the Fed was absorbing duration risk. Now it's positive again. Lucas: That's a huge shift. In the 2010s, the term premium on 10-year Treasuries was negative — investors were willing to accept lower yields just to hold safe long-term assets. That compressed the curve. Today, with inflation uncertainty and large fiscal deficits, the term premium is back to positive territory, maybe 30 or 40 basis points. That steepens the curve, which is actually a normalisation. Luna: So the Fed watches the term premium to gauge whether long rates are driven by inflation expectations or by real supply and demand. If the term premium rises because of deficit concerns, that's different from rising inflation expectations. Lucas: Exactly. And they've become more explicit about it. In the 2023 and 2024 FOMC minutes, there's a lot of discussion about term premiums and whether the backup in yields was doing the tightening for them — a so-called 'tighter for longer' dynamic coming from the bond market rather than from rate hikes. Luna: That's actually one of the ways central banks use the yield curve as a policy tool indirectly. They communicate that they're watching it, and that shapes expectations. Lucas: Right. Forward guidance is another direct tool. When the Fed says 'we expect to keep rates low until 2024', that's a promise about the short end. But it also influences the whole curve, because investors extrapolate. If they believe the commitment, they'll price in lower short rates for longer, which pulls down long yields too. Luna: But forward guidance only works if the market trusts the Fed's commitment. And in an environment where the Fed has had to reverse course — like when they said inflation was transitory in 2021 then hiked aggressively — that trust erodes. Lucas: That's the credibility problem. And it's why yield curve control is so risky. If the market doesn't believe your target is consistent with inflation, they'll test it. The BOJ faced that from 2022 to 2024. The Fed has never gone that far, but they did use a version of it during the pandemic with their yield curve caps on Treasury bills — a very short-term intervention. Luna: I remember that. In March 2020, they bought short-dated Treasuries directly to keep the bill market functioning. But that was about liquidity, not about signalling policy. Lucas: Right. And that's a good distinction. When the central bank intervenes in a specific part of the curve to fix a breakdown — like the repo market spike in September 2019 — that's a plumbing operation. When they intervene to change the overall level of rates, that's policy. Both affect the yield curve, but the intent is different. Luna: So let's bring it back to the listener. If you're watching the yield curve, what should you look for to understand what the central bank is actually doing? Lucas: Two things. First, watch the 2-year yield — it's most sensitive to the policy rate expectation. If it falls sharply, the market expects cuts. Second, watch the term premium on the 10-year — that tells you whether long rates are moving because of growth and inflation expectations or because of supply and risk. The Fed's own staff produce a term premium estimate, and you can see it in their quarterly surveys. Luna: And if the term premium is rising while the 2-year yield is flat, that might mean the bond market is worried about fiscal sustainability, not monetary policy. Lucas: Exactly. That's a scenario where the central bank might feel pressure to adjust its own holdings — maybe by slowing the pace of quantitative tightening to avoid adding to long-term supply. That's exactly what we saw in 2025: the Fed paused balance sheet runoff partly because they didn't want to push term premiums up further. Luna: So the yield curve is both a message board and a control board. Markets write messages on it, and central banks use it to steer. Lucas: Well put. And the more tools central banks accumulate, the more active that control board becomes. The key is knowing which tool maps to which part of the curve — and whether the market is buying the signal. Luna: I think that's a good place to leave it. Next time, maybe we talk about how all this affects the mortgage market — because that's where the yield curve hits home for most people. Lucas: That's a great idea. We'll see you then.