Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Are Now Targeting the Whole Yield Curve
Transcript
- Lucas: So we've spent a lot of episodes talking about how central banks target the very short end of the interest-rate spectrum — the policy rate, the overnight rate. But there's another approach where the central bank essentially says, 'We're not just controlling the short end, we're going to pick a yield further out the curve and cap it there.' That's yield curve control. Luna: And the go-to example here is the Bank of Japan, right? They've been doing this since 2016. Lucas: Exactly. In September 2016, the Bank of Japan announced it would target a zero percent yield on ten-year Japanese government bonds. Not a range, not a forecast — a hard cap. They committed to buying as many ten-year JGBs as needed to keep that yield at zero. This is fundamentally different from quantitative easing. Luna: How so? Because with QE, the central bank is buying bonds to push down yields overall, but not targeting a specific level, right? Lucas: Right. With QE, you announce a quantity of purchases — say, $80 billion a month — and you let the market determine where yields settle. Yield curve control is the opposite: you announce a price target for a specific maturity, and you let the quantity of purchases be whatever it needs to be. The central bank gives up control over its balance sheet size to enforce that yield cap. Luna: So the balance sheet becomes a residual. That feels like a big commitment. When does a central bank decide it needs this tool? Lucas: Typically when short-term rates are already at or below zero and you still need more stimulus. The Bank of Japan had negative rates by early 2016, but inflation was still stuck around zero. They needed to pull down longer-term borrowing costs — for mortgages, corporate bonds — to spur demand. So instead of just buying bonds in a QE program, they put a ceiling on the ten-year yield. Luna: And it worked for a while. I remember reading that Japanese ten-year yields barely budged for years — they were essentially pegged at zero. Lucas: That's right. From 2016 through 2020, the ten-year JGB yield hovered between roughly negative 0.2 percent and positive 0.2 percent. Very stable. But then global inflation picked up in 2021 and 2022, and other central banks started raising rates aggressively. That put pressure on the BoJ's yield cap because investors could get much higher yields elsewhere. The BoJ had to buy enormous quantities of JGBs to defend the cap — its balance sheet ballooned. Luna: Yeah, I recall they had to adjust the target band. In 2021 they widened it to plus or minus 0.25 percent, then in 2022 to 0.5 percent, and more recently to 1.0 percent. Each time the market tested them. Lucas: Exactly. And that's the inherent tension with yield curve control. The market can vote against your target. If investors believe inflation will stay high, they'll sell bonds, pushing yields up. The central bank then has to buy more and more to hold the line. It becomes a battle of credibility versus market forces. The BoJ has spent trillions of yen defending that cap. Luna: It sounds like a tool that works beautifully in a low-inflation, low-growth environment, but gets very painful when the macro backdrop shifts. Lucas: That's a fair summary. And that's why most other major central banks have been reluctant to adopt it. The Federal Reserve studied yield curve control after the global financial crisis and again during COVID — they even flirting with it in 2020 — but ultimately decided against. They preferred forward guidance and QE. Luna: But the Bank of England actually did it briefly, didn't they? In 2022 during the pension crisis? Lucas: Yes, a very interesting case. In September 2022, the UK government's mini-budget triggered a massive sell-off in gilts, especially long-dated ones. Liability-driven investment funds were on the verge of collapse because their collateral was plunging. The Bank of England stepped in with a temporary, targeted form of yield curve control — they announced they would buy long-dated gilts at whatever yield necessary to restore order. They didn't call it yield curve control, but that's effectively what it was: a price cap on long-term yields. Luna: And it worked. They bought about 19 billion pounds' worth over two weeks, and yields came down. But they were very clear it was temporary. Lucas: Exactly. They framed it as a financial stability intervention, not a monetary policy tool. That's key. Because once you start using yield curve control for monetary policy, you blur the line between fiscal and monetary policy. The central bank is essentially financing the government's debt at below-market rates. That raises questions about independence. Luna: So is the Bank of Japan's experience a cautionary tale or a success story? They did manage to get inflation above 2 percent for the first time in decades. Lucas: It's complicated. On one hand, yield curve control helped support the economy during a deflationary period. On the other hand, it left the BoJ with a massive balance sheet and a credibility problem when inflation picked up. They've been slowly loosening the cap, but they haven't fully exited yet. The ten-year yield is still capped at 1.0 percent as of mid-2026. So it's an ongoing experiment. Luna: And there's the issue of market functioning. When the central bank dominates the market for a specific maturity, price discovery is basically gone. The ten-year JGB market is essentially the BoJ. Lucas: That's a huge cost. Investors lose a reliable benchmark for pricing other assets. Insurance companies, pension funds — they need a free-market yield curve to match their liabilities. When the central bank flattens that curve artificially, it distorts long-term savings and investment decisions. Luna: So what's the bottom line for a central banker considering this tool? When would you use it? Lucas: I think the honest answer is: only when you're truly out of other options. If the policy rate is at the effective lower bound and QE has lost its punch, and the economy is still stuck in a liquidity trap, then yield curve control is worth considering. But you have to have a credible exit strategy. The Bank of Japan didn't have one, and that's why they've been stuck with it for a decade. Luna: It's fascinating that we're talking about this in 2026, because many central banks are now normalizing policy after the inflation surge. But Japan is still the outlier, still using a crisis-era tool. Lucas: And that's worth watching. If the BoJ eventually has to abandon the cap entirely, we could see a sharp sell-off in JGBs that ripples through global bond markets. It's one of those tail risks that keeps bond traders up at night. But for now, the Bank of Japan is sticking with it, and the rest of the world is watching closely. Luna: It really makes you appreciate how much thought goes into choosing the right policy tool. Each one has trade-offs, and yield curve control is no exception. Lucas: Absolutely. And you know, it's conversations like this that make me glad we can dive deep into these topics without worrying about sponsors. We deliberately keep this show ad-free so we can focus on what's interesting, not what sells. Luna: Yeah, same here. And listeners who find value in that have a way to support us if they want. Lucas: Exactly. If walking through the economy with us has made something click, you can find us at buy me a coffee dot com slash fexingo. It's a simple way to help keep this exactly what it is. Luna: Totally optional, but appreciated. And we're back to the topic. So, Lucas, do you think we'll see yield curve control used again by a major central bank outside Japan? Lucas: I think it's unlikely in normal times, but never say never. The UK's 2022 episode showed that even in a deep financial crisis, a central bank will reach for whatever tool works. The key is to use it temporarily and for a clear purpose. If another crisis hits and short rates are at zero, I could see the Fed or ECB dusting off their playbooks and considering a yield cap on intermediate maturities, say five years. But they'd need to be very careful. Luna: So it's a tool for emergencies, not for steady-state policy? Lucas: Exactly. In the Japan case, it became steady-state, and that's where the problems start. For most central banks, yield curve control should be like a fire extinguisher — good to have, but you hope you never need to use it. Luna: Great way to put it. Thanks for walking us through this, Lucas. I think I have a much better handle on why the BoJ's policy is such a big deal. Lucas: My pleasure. It's one of those topics that sounds exotic but is really just an extension of the same logic central banks use every day. Next time, let's talk about how they're using forward guidance in a world of uncertainty.