First just a note on Brad’ chart about the BBB spread. IIRC the ML BBB effective yield does not map directly on to the 10-year. However, ML does produce its own spread analysis over spot Treasuries.

FRED Graph

Same general effect but the relative magnitude of recent movements is a bit less.

More substantively Brad says

Suppose we tried monetary policy to move the IS curve:

Announce that we will buy bonds for cash all along the yield and risk curve when the 10-Year nominal Treasury rate was less than 4%/year and keep doing so until it hit 4%/year; announce that we will sell bonds for cash all along the yield and risk curve when the 10-Year nominal Treasury rate was more than 4%/year and keep doing so until it hit 4%/year.

Why wouldn’t that be an absolutely fine monetary policy? Wouldn’t that be a much better than the one we are following now, wouldn’t it?

My guess is that you are likely to get some sort of knife-edge instability here if you are standing ready to trade in unlimited quantities.

So, if people expect the yield to 4% and it is we are fine. Now, suppose some shock hits the US economy and drops the expected yield. The Fed then buys Treasuries to expand the money supply. This will raise expectations of future growth and in principle, raise the yield on the 10 year back to where it was.

However, how is the 10 year going to actually get there when as long as its below trend level the Fed keeps applying downward pressure on the yield by buying? You in effect have the problem that: the Fed can stay irrational longer than you can stay solvent.

You want to sell the 10 on expectations of future growth but you can’t profitably do this because you know the Fed is committed to unlimited buying so long as you are not selling more than they are buying. Thus, the stability condition is something the private market can never satisfy.

The way this could work is that the Fed promises to buy X amount every Tuesday unless the close on Monday was 4%. Thus the market has time to rationalize without being offset by Fed action.

I think that could work.

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