Global Daily – Introducing Dynamic Yield Curve Control

ECB Chief Economist Philip Lane elaborated on the ECB’s reaction function to rising government bond yields in an interview in the Financial Times (see here). Mr Lane explained the importance of anchoring yield curves noting that ‘our objective is basically to make sure that yield curves – which play an important role in determining overall financing conditions – do not move ahead of the economy. Because, as you know, financial markets are very forward-looking and you can have a steepening in yield curves which is not conducive to maintaining progress in terms of the inflation dynamic. It is really a shift in monetary policy away from focusing on just the short-term rate by looking at all financing conditions. For many economic decisions, especially under the conditions we have now, the longer end also matters’.

The level that the ECB would find appropriate depended on the inflation outlook. He clarified that ‘our favourability assessment of financing conditions is dynamic. It does depend on how much progress we are making in terms of the inflation forecast. It is not yield curve control in the sense of saying we want to keep the yield curve at some fixed value; because over time the relation between the appropriate level of yields and inflation will move’. This amounts to what we call ‘Dynamic Yield Curve Control’. A specific level of yields would be desirable given the current inflation outlook, but this will change as the inflation outlook evolves in either direction.

The ECB’s Chief Economist also hinted at what level of yields is currently appropriate given the current outlook for inflation. He talked very specifically about the yield curve in mid-December and the need to restore that rather than to go below that. He asserted that ‘everyone would agree that by our December meeting what we had was a pretty flat yield curve compared to our deposit rate. If you look at the risk-free rates going out ten years, that curve had never been so flat. What is true is that we could lower the deposit rate. In that sense, we don’t think we are at the lower bound. To me it is an efficiency issue: rather than focus on pushing down the curve compared to the mid-December level, monetary accommodation could be better provided by preserving favourable financial conditions, especially in responding to a tightening that would be inconsistent with offsetting the pandemic shock to the inflation path’.

The ECB’s main focus is the average eurozone government bond yield curve weighted by GDP. In mid-December the 10y ranged at around -0.18 to -0.2% compared to levels of around zero at the time of writing. Back in December, the 10y Bund yield was just below the deposit rate at -0.52 to -0.54%, compared to -0.34% currently. However, an average eurozone yield of around -0.2% can of course be achieved by different constellations of individual country yields. In particular, country spreads are a bit tighter than they were back in December, and all things considered, a somewhat higher Bund yield could be consistent with the same average yield target.

Positive tone on average inflation targeting – Mr Lane also discussed the ECB’s strategy review and he saw a case for some kind of make-up framework. He explained that ‘we are right in the middle of the strategy review and everything is still under analysis. The interesting question is if there is a strategic commitment that following a period of undershooting you signal that the correction phase is not just going to the target but going moderately above the target for a period. I think there is a very strong logic to that’. However, he went on to say that this should be implemented flexibly, arguing that ‘no one would go for a strict version of averaging where a period of inflation above target inflation would require engineering a subsequent period of below-target inflation to hit the average…there is a very strong analytical case for flexible average inflation targeting’. However, he added that ‘there are other options that may also be successful in anchoring inflation expectations’. One downside of a make-up strategy was that ‘there are communication issues here. Now, these are not necessarily insoluble communication issues. But as you know, across Europe there are very different histories of inflation and the history of inflation in some European countries is very different to the American experience’.

A symmetric 2% target seems to be nailed on as an outcome for the ECB’s strategy review. Based on earlier comments from Lagarde, it seemed more doubtful that this 2% symmetry would be implemented as an average target over time, involving periods where the central bank would target below or above target inflation to make up for past misses. However, Mr Lane’s comments suggest that the ECB might be warming to the idea, albeit with the caveat that it is far from being a done deal at this point.