BREAKINGVIEWS-Guest view: Defanged Fed faces yield curve dilemma

By Michael Pedroni

WASHINGTON, Sept 12 (Reuters Breakingviews) - The Federal Reserve may soon be dusting off a tool it has not used in more than 70 years: yield curve control, or YCC. If President Donald Trump and his administration unravel the central bank’s independence, markets will drive up long-term Treasury bond yields, prompting the government to take forceful measures to contain the impact on its borrowing costs. In practice, that would mean the Fed committing to large-scale purchases of Treasuries to cap or manage long-term interest rates.

It sounds radical, but is not without precedent. The Japanese and Australian central banks experimented with YCC in the past decade to escape deflation. During the Covid shock in 2020, the Fed briefly weighed YCC but ultimately dismissed it as ill-suited to U.S. markets. Policymakers concluded they had enough credibility to push long-term rates lower through forward guidance, without binding themselves to a formal cap.

These actions were considered by independent central banks which had reached the limits of conventional monetary policy. Today's Fed faces no such constraint. A return to YCC would therefore mark a return to its role during and after World War Two, when it was subordinated to the Treasury and required to cap yields to finance massive government deficits.

Trump’s administration appears far less concerned with recent precedent. Since taking office, both the president and Treasury Secretary Scott Bessent have openly pressured the Federal Open Market Committee (FOMC) to cut interest rates, despite stubborn inflation. Trump is seeking to remove Fed Governor Lisa Cook and ensure a plurality of loyalists on the central bank’s board. “We’ll have a majority very shortly, so that’ll be great,” he remarked recently — though a federal judge on Tuesday temporarily blocked Cook’s removal.

The Fed’s independence is therefore already on life support. Investors will gradually recognize that monetary policy is being steered from Pennsylvania Avenue. And while the FOMC controls short-term rates, long-term yields which are mainly determined by investors are likely to grind higher.

To be fair, the politicization of the Fed has been decades in the making. Since the 2008 global financial crisis, the central bank has repeatedly stepped in to accommodate Treasury’s need to manage long-term rates. For 55 years prior, the Fed’s balance sheet crept forward at a glacial pace, remaining under $1 trillion as of 2008. In 2009, the Fed added another $1 trillion of bonds through quantitative easing. The balance sheet continued to expand in the years that followed, and during the Covid crisis the Fed went even further — buying a staggering $4 trillion in Treasuries and mortgage-backed securities and inflating its balance sheet to nearly $9 trillion by 2022.

What began as an emergency response has now put the Fed at risk of acting as a permanent financier of government spending. Jitters that the Trump administration will fully disassemble the Fed’s independence have led markets to fire a warning shot. Long-term Treasuries have underperformed shorter-dated bonds, reflecting concerns over inflation, growth, and fiscal risks. The difference between the yield on 30-year and 2-year Treasuries widened by 17 basis points in the week after Trump said he had “fired” Cook this month. The gap has increased by 62 basis points so far this year, though it has been much wider in the past when the Fed was in crisis-fighting mode.

Rising long-term yields mean higher debt-service costs for the government and punitive mortgage rates for households. This administration is unlikely to accept either outcome. That sets the stage for a compliant Fed to be directed to cap long-term rates by buying bonds outright. Call it what you will, but the result will be YCC.

Some economists and policymakers have called for more explicit coordination between fiscal and monetary authorities. Kevin Warsh, a former Fed governor and one of the frontrunners to replace current Chair Jerome Powell, has argued that the 1951 Accord restoring Fed independence is ripe for a “strategic reset.” Speaking to the Group of Thirty (G30) at the International Monetary Fund in April — a lecture many viewed as his audition for the role — he proposed a framework where Treasury would map its debt issuance, while the Fed would clarify its balance-sheet plans — maintaining “operational” independence while coordinating more closely with fiscal policy.

In today’s hyper-politicized environment, that distinction collapses. A Fed dominated by Treasury priorities will inevitably slide into YCC as it tries to suppress long-term interest rates.

Even if the Fed succeeded, however, such a shift would come with nasty side effects. YCC could facilitate bigger tax cuts or government spending, stoking inflation and undermining the central bank's core mission of maintaining price stability. It would once again expand the Fed's balance sheet, which has shrunk to less than $7 trillion in recent years. Unexpected or poorly telegraphed moves could also whipsaw yields, making it harder for bond markets around the world to use Treasuries as a price benchmark.

As market jitters push up the federal government’s borrowing costs, the pressure to implement YCC will increase. The only beneficiaries will be the traders who anticipate the shift and stand to profit from the Fed’s eventual large-scale purchases of long-dated government bonds.

CONTEXT NEWS

Michael Pedroni is founder and CEO of Highland Global Advisors, a policy, regulatory and political risk advisory firm for financial services and technology companies.