The Central Bank and the Yield Curve

In a recent post it was noted that the central bank could dictate longer interest rates if this were deemed appropriate. This deserves brief elaboration. The relevance of the observation is not that it would necessarily be a desirable policy, but rather that in a modern monetary system – one in which the government is the monopoly issuer of its own flexible exchange-rate currency – ultimately interest rates on sovereign debt are at the discretion of the central bank. The government chooses the form of debt it issues and the central bank can control the interest rates applying to that debt. It follows that the government’s risk of facing “unsustainable” interest obligations, in the neoclassical sense of causing runaway inflation, is eliminated barring deliberately self-destructive policy.

When Modern Monetary Theorists say that the central bank could dictate all interest rates, including longer ones, they mean that the central bank could use a price rule rather than a quantity rule. This is what central banks currently do in many countries in hitting their short-term interest rate targets (in some countries, a simpler procedure of paying interest on reserves has been adopted in the aftermath of the global financial crisis). The central bank could say it will stand ready to buy or sell whatever amount of debt of particular maturity is necessary to maintain its target for that interest rate, just as it stands ready to maintain its target short-term rate. Since the consolidated government sector (including fiscal and monetary authorities) faces no financial constraint, the central bank has the capacity to do this.

But this is not to suggest that such an approach is necessary, or even desirable, when it comes to longer interest rates. The important point is that, ultimately, interest rates have a monetary/political determination, not a real determination, and are at the discretion of the central bank. I discuss this point further in Interest, Money and Crisis.

The observation that interest determination is a matter of political economy is a critical one. Some neoclassical economists attempt to show that ongoing government net spending creates an excessive interest obligation that, when paid, gives rise to runaway inflation by causing demand to outstrip the capacity of the economy to respond. This fear subsides once it is understood that interest rates are at the discretion of the central bank.

In practice, it is not necessary to dictate longer rates. The Treasury and central bank, working in tandem, can instead do one of two things:

1. Stop issuing debt and just pay the target rate on reserves; or

2. Only issue short-term debt so that short-term rates are the only relevant ones for fiscal “sustainability” in the neoclassical sense.

Since the central bank controls the short-term rate, and even more easily can control the rate paid on reserves, the interest obligation on public debt is directly controllable. So long as fiscal policy is pursued with an eye to both strong employment outcomes and price stability, there will be little reason to fear excessive inflation.