How About Pegging a Long Term Interest Rate ?

As often, Paul Krugman has an extremely interesting thought. Discussing the sudden end of the Swiss Franc Eur peg he wrote

This in turn helps us put the explicit exchange rate target into the right slot: it was about making QE effective through commitment, so that you got the maximum impact on expectations. Actually, the success of the currency program suggests that other central banks might want to try things like setting a ceiling on some long-term interest rate.

I think the paragraph is pretty clear but will try to explain a bit more. There are two huge advantages of a peg. First the rule for maintaining one is very simple — just sell at a price as much as people want to buy and buy as much as they want to sell at that price. Also, whenever markets are open, people can see if it is being maintained . We can see that the Fed is sticking to its declared target federal funds rate immediately. It always does. I’m sure the Federal funds rate is perceived by some (of the those who know what it is) to be an instrument under the administrative control of the Fed.

The Fed could declare that the 10 year constant maturity treasury rate shall be no higher than 1% and then make it so by buying enough notes and bonds.

I see two questions. First which long term interest rate ? Second, what might go wrong ?
The interest rates the Fed would most like to set are interest rates on risky assets such as mortgage bonds or at least low grade corporate bonds. The problem here is that the say the Baa corporate bond rate is an average of the rates on many different bonds. If the Fed were to promist to buy any of them at a yield of 2% say, then it would buy the worst Baa bonds. Pegging one price for a bunch of different things is the perfect way to achieve adverse selection. I think that it is much more practical to set a long term Treasury rate.

Now the 10 year constant maturity rate isn’t the return on a particular note or bond. It is an index calculated with a complicated formula. However, it is calculated with a standard formula and can be recalculated very quickly. All the different Treasury securities the returns on which are involved in the calculation are equally safe.

To simplify, I am now going to consider a silly but simple target in which the Fed puts a ceiling on the return of a particular bond which I will call the target bond. That is equivalent to setting the price of that bond and this can be achieved buy buying or selling unlimited amounts at that price.
OK so what could go wrong ? Here I think the problem is that it might be that to keep the price of the target bond at the desired floor (so the yield at the desired ceiling) the Fed would have to buy exactly 100% of the target bonds that have been issued. Then the market for the target bond would freaze with the Fed offering to sell it for a price higher than anyone is willing to pay.
The effect of the simple policy would be to eliminate an asset. Returns on very similar assets which are not bought and sold by the Fed might be very different.

This silly result is partly due to my considering the silly so simple I could do it policy. But I think that it illustrates a real problem with setting a ceiling on a long term interest rate -the yield curve is flexible and pushing on one part of it doesn’t have to move all of it. I think there is a tradeoff between setting a simple well defined long term interest rate target the monetary authority can actually reliably hit and influencing a large part of the huge set of long term interest rates which matter.

I think there is a lot of devil in the detail of choosing “some long-term interest rate”.