Simply Put: Yield curve control

Ram and Bhim are sitting in their favourite café and it’s not long before they start discussing their investments and the broader markets:

Bhim: What is this Yield curve control thing going on with Bank of Japan? What exactly is it?

Ram: Ok, Yield curve control is the activity where central banks perform open market operations to achieve a target rate of the bond yield (usually long-term bond) as desired by them. For the last few years, Bank of Japan (BOJ) has been implementing Yield curve control to keep interest rates at the desired level.

Bhim: Is that not Quantitative easing?

Ram: It sounds like Quantitative easing but differs from it in one key aspect. In Quantitative easing, the central bank fixes the value of bonds that it plans to buy from the markets, thereby infusing liquidity into the system, and due to this the yields come down. In the case of Yield curve control, the central bank first decides on the longer-term target rate and then buys whatever bonds the market has to offer to achieve it.

What is Yield curve control and what it means for investors  What is Yield curve control and what it means for investors  

Bhim: But why do the central banks do it? Can’t they just change interest rates in monetary policy?

Ram: Central banks change only short-term interest rates in monetary policy. During times of economic slowdown, the central banks, to stimulate the economy, reduce short-term interest rates. However, it may so happen that due to uncertainty and fears of inflation in the long term due to easy money, there may be fewer takers for long-term bonds and therefore may require higher yields. Yield curve control solves this problem by buying the long-term bonds and maintaining the yields at a particular level. Through this method, the central bank can keep interest rates lower for a longer period which, along with stimulating the economy, will also keep the borrowing cost of the government lower.

Bhim: Is there any disadvantage to Yield curve control?

Ram: The major disadvantage is that central banks cannot be flexible with Yield curve control; i.e., once this is implemented, it becomes necessary for the central banks to continue this arrangement for some time in the future, else it would tarnish the reputation and credibility of the bank. In addition, due to lower interest rates, the risk of inflation always persists.

Bhim: Looks like a double-edged sword to me.

Ram: It is indeed.

Bhim: But does it matter to us in India?

Ram: Any change in the stance of the BOJ to abandon its Yield curve control can pressure global markets as it can change the dynamic of the yen carry trade i.e., borrowing in yen at cheaper rates and investing in foreign assets with better yields. So, stay alert to what the BOJ is doing.

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