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The Federal Reserve has been at the forefront of the effort to stabilize capital markets amid the unprecedented disruption created by the novel coronavirus (Covid-19). With its conventional monetary policy tools (mostly interest rate cuts) largely exhausted, the central bank has had to innovate on the fly.
Throwing caution to the wind, the Fed has promised to provide essentially infinite liquidity. It has also intervened in the corporate bond market for the first time in its history. Sidestepping the legal barriers of its mandate, the Fed - with an assist from BlackRock Inc. (BLK) - has financed the Treasury's purchase of bond ETFs.
Now the Fed is thinking even bigger, openly considering the possibility of conducting similar interventions in the stock market. While this is unknown territory for the American central bank, it is well-trod territory for others. The Bank of Japan (BOJ), in particular, has been a pioneer of central bank stock buying. Its experience can offer important lessons, both to Fed officials and the investing public.
Conventional monetary policy insufficient
After declining about 50% from its valuation set in December 1989, Japan's asset price bubble finally burst in 1992, throwing the domestic economy into disarray. Japan suffered through a "lost decade" that left many Japanese citizens, workers and investors permanently scarred.
As the government grappled with what was to become a protracted economic downturn, the BOJ was forced to take an ever expanding role. Indeed, by the late 1990s, the central bank had taken center stage in the war on Japan's great economic enemy: deflation.
Despite the BOJ's best efforts and aggressive deployment of conventional monetary policy tools, deflation's stubborn grip on the Japanese economy could not be broken. By late 2002, the BOJ's orthodox policy arsenal was essentially exhausted. The central bank decided it was time to explore new and uncharted policy waters.
Deploying new policy weapons
At the urging of the national government, the BOJ made a historic move: It started buying equity ETFs. This major central banking innovation, and its subsequent use for nearly a decade, has cemented the BOJ's reputation as a trailblazer, as Bloomberg observed on April 5:
"Japan is to central banking what the old Bell Labs was to the global tech industry: a hotbed of ideas that get adapted by others. Going back to the late 1990s, it was forced to pioneer unorthodox methods to try to spur growth and restart the economy's credit machine. In doing so, it's shown other central banks that they have a broad array of options when they've already cut interest rates to zero."
The BOJ's war on deflation has made it a true innovator among central banks. It has developed and deployed an array of novel policy tools in its efforts to battle deflationary pressures. But their results have been mixed.
Mission not accomplished
The BOJ maintained its stock buying actions throughout the long post-Great Recession economic expansion. It played a significant role in propelling stocks ever upward, contributing to the longevity of what would become the longest bull market in history. By April 2019, Japan's central bank was a top ten shareholder of more than 50% of publicly traded companies. Even so, the BOJ's efforts have still failed to achieve all of its goals.
Even though it has poured money into the market, the Nikkei index failed to rise toward the all-time highs set in 1989. Moreover, deflationary pressures have continued to plague the economy.
While the BOJ's stock buying has undoubtedly helped to buoy the Japanese stock market, it has fallen short of its goal of defeating deflation for good, and has failed to restore the full confidence in public markets that was lost in the chaotic 1990s.
A new enemy at the gates
The BOJ has been forced to contend with another economic foe in recent months in the form of Covid-19. As global stock markets began to plummet last month, the BOJ opted to step up its stock buying efforts. On March 16, BOJ Governor Haruhiko Kuroda announced that the central bank would double the pace of its equity purchases to $113 billion per year. The announcement helped to stabilize market sentiment somewhat, but stocks have failed to recover completely - unsurprising given the virtual shutdown of much of the global economy.
The BOJ has paid a high price for its equity market interventions. On March 24, the BOJ acknowledged the impact of the market rout on its vast stock ETF holdings. The BOJ cited a whopping unrealized loss of $18 billion to $27 billion, raising the prospect that it might actually post a loss for the year - a rather unusual state of affairs for the central bank of a developed country, by any measure.
The BOJ has not posted an annual loss in four decades, but its massive, and still growing, exposure to the stock market will only serve to make such occurrences more common. While bull markets may pad its balance sheet, any significant downturn is liable to put a serious dent in the central bank's financial statements.
As the Fed mulls its options for additional policy interventions, it should consider the lessons of the BOJ carefully before taking a similar plunge. ETF purchases can juice up stocks, but they are far from a perfect tool, as the BOJ has learned to its cost amidst the recent selloff. Moreover, any effort to unwind such a policy would almost certainly roil markets.
While the prospect of propping up equity markets through direct intervention may be appealing to Fed officials, they would be wise, in my estimation, to err on the side of caution. It seems most prudent to keep that particular genie in its bottle, regardless of its potential short-term utility.
Disclosure: No positions.
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This article first appeared on GuruFocus.