It is clear that the central bank can use balance sheet management techniques to control yields on public debt at certain targetted maturities. However, the presence of high inflation reduces the effectiveness of this strategy.
Answer: True
The answer is True.
I was going to use the term "economic impact" but decided against that because it might be misleading given that it would require a discussion of what an economic impact actually is. I consider an economic impact has to involve a discussion of the real economy rather than just the financial dimensions.
In that context you would then have had to consider two things: (a) the impact on private interest rates; and (b) whether interest rates matter for aggregate demand. And in a simple dichotomous choice (true/false) that becomes somewhat problematic.
I chose the alternative "impact on the term structure" because it didn't require any consideration of the real economy but only the impact on private interest rates.
The "term structure" of interest rates, in general, refers to the relationship between fixed-income securities (public and private) of different maturities. Sometimes commentators will confine the concept to public bonds but that would be apparent from the context. Usually, the term structure takes into account public and private bonds/paper.
The yield curve is a graphical depiction of the term structure - so that the interest rates on bonds are graphed against their maturities (or terms).
The term structure of interest rates provides financial markets with a indication of likely movements in interest rates and expectations of the state of the economy.
If the term structure is normal such that short-term rates are lower than long-term rates fixed-income investors form the view that economic growth will be normal. Given this is associated with an expectation of some stable inflation over the medium- to longer-term, long maturity assets have higher yields to compensate for the risk.
Short-term assets are less prone to inflation risk because holders are repaid sooner.
When the term structure starts to flatten, fixed-income markets consider this to be a transition phase with short-term rates on the rise and long-term rates falling or stable. This usually occurs late in a growth cycle and accompanies the tightening of monetary policy as the central bank seeks to reduce inflationary expectations.
Finally, if a flat terms structure inverts, the short-rates are higher than the long-rates. This results after a period of central bank tightening which leads the financial markets to form the view that interest rates will decline in the future with longer-term yields being lower. When interest rates decrease, bond prices rise and yields fall.
The investment mentality is tricky in these situations because even though yields on long-term bonds are expected to fall investors will still purchase assets at those maturities because they anticipate a major slowdown (following the central bank tightening) and so want to get what yields they can in an environment of overall declining yields and sluggish economic growth.
So the term structure is conditioned in part by the inflationary expectations that are held in the private sector.
It is without doubt that the central bank can manipulate the yield curve at all maturities to determine yields on public bonds. If they want to guarantee a particular yield on say a 30-year government bond then all they have to do is stand ready to purchase (or sell) the volume that is required to stabilise the price of the bond consistent with that yield.
Remember bond prices and yields are inverse. A person who buys a fixed-income bond for $100 with a coupon (return) of 10 per cent will expect $10 per year while they hold the bond. If demand rises for this bond in secondary markets and pushes the price up to say $120, then the fixed coupon (10 per cent on $100 = $10) delivers a lower yield.
Now it is possible that a strategy to fix yields on public bonds at all maturities would require the central bank to own all the debt (or most of it). This would occur if the targeted yields were not consistent with the private market expectations about future values of the short-term interest rate.
If the private markets considered that the central bank would stark hiking rates then they would decline to buy at the fixed (controlled) yield because they would expect long-term bond prices to fall overall and yields to rise.
So given the current monetary policy emphasis on controlling inflation, in a period of high inflation, private markets would hold the view that the yields on fixed income assets would rise and so the central bank would have to purchase all the issue to hit its targeted yield.
In this case, while the central bank could via large-scale purchases control the yield on the particular asset, it is likely that the yield on that asset would become dislocated from the term structure (if they were only controlling one maturity) and private rates or private rates (if they were controlling all public bond yields).
So the private and public interest rate structure could become separated. While some would say this would mean that the central bank loses the ability to influence private spending via monetary policy changes, the reality is that the economic consequences of such a situation would be unclear and depend on other factors such as expectations of future movements in aggregate demand, to name one important influence.
That is enough for today!
(c) Copyright 2022 William Mitchell. All Rights Reserved.