RBA won’t target bond yields after messy exit

The Reserve Bank is unlikely to repeat its policy of targeting a yield for a government bond after suffering reputational damage from a disorderly exit from the policy last year.

Reserve Bank of Australia governor Philip Lowe. Picture: NCA

The Reserve Bank is unlikely to repeat its policy of targeting a yield for a government bond after suffering reputational damage from a disorderly exit from the policy last year, a review of the program has found.

Bond purchases are likely to be the preferred way of insuring against “very bad economic outcomes” at times when an already low level of interest rates limits the scope for lowering the cash rate, it concluded.

A target for the yield on three-year Australian government bonds of 0.25 per cent was set by the RBA after an emergency meeting in March 2020, following a near meltdown of the market during which the 3-year bond yield spiked from 1.15 to 2.5 per cent. That policy was designed to signal that interest rates would stay low for years.

The RBA said in March 2020 that it “will do what is necessary to achieve the 3-year yield target” by direct intervention in the bond market and the policy was “expected to remain in place until progress is being made towards the goals for full employment and inflation.”

But the policy was suddenly abandoned in November 2021 amid sustained upward pressure on the yield in the market as traders bet that interest rates would rise. “The time-based forward guidance implicit in the yield target helped to ease financial conditions in the extraordinary days of the pandemic, but carried risks in the highly uncertain economic environment,” the review said. “As the distribution of possible economic outcomes shifted with the economic recovery, the yield target was not well suited to respond.”

While the yield curve target succeeded in achieving its objectives of lowering funding costs and supporting the provision of credit to the economy, “the exit in late 2021 was disorderly and associated with bond market volatility and some dislocation in the market,” the review found.

“This experience caused some reputational damage to the bank,” it said, although it did not quantify how much the RBA’s credibility had suffered.

It noted that many other central banks have also been surprised by the strength in the economic recovery and inflation, with associated reputational costs and large movements in market prices as forecasts and the forward guidance based on them have not been met.

But the target came to be understood by most market participants as a commitment to maintain the yield on the bond in question close to the target until the time that it matured.

“The ending of the yield target was challenging for a number of financial market participants, including those that expected the target to be retained,” the RBA said. “As such, this experience could lessen the effectiveness of any future commitments of this nature by the bank.”

“Ultimately, the degree of credibility and reputational cost from the yield target policy is likely to be determined by longer-term outcomes and broader assessment of the package of policy measures and their effectiveness in contributing to attainment of the bank’s goals.”

In a speech to the American Chamber of Commerce, RBA governor Philip Lowe conceded that the bank may have had “too much focus on downside risks to the economy and the need to insure against them, and too little focus on the possibility that things could work out better than expected.”

“But in real time, in which decisions had to be made under great uncertainty, the review notes that the focus on the downside risks was understandable,” Dr Lower said. “The board recognises that opinions will differ as to whether it struck the right balance.”

According to the review, the Board viewed the probability of using a yield target again in future as low, but recognised that the use of a yield target might be appropriate in extreme circumstances, albeit in a form that incorporates the lessons learned from this experience.

The use of a yield target in the future would need to be evaluated against other policy options, including a bond purchase program, otherwise known as quantitative easing.

While quantitative easing offers more flexibility, it can cause larger potential financial costs and the possibility of impaired bond market functioning as central bank bond holdings increase, and there can also be challenges in unwinding a large bond purchase program, Dr Lowe noted.

The RBA will review its QE program and forward guidance on monetary policy later this year.

Originally published as RBA won’t target bond yields after messy exit