The pitfalls and lessons for the Fed as it steps into uncharted territory.

The Fed could take a leaf out of the Bank of Japan’s (BOJ) ETF playbook to address the current economic crisis created by the coronavirus pandemic. The Fed has already taken a never-before step by announcing it stood ready to buy bond ETFs. If its current fire-fighting moves come up short, it might even have to buy stock ETFs – something the BOJ is a past master at. (Bloomberg Businessweek)

Japan’s lost decade

Back in the 1990s, the Bank of Japan had to combat an unprecedented situation. Massive stock and property bubbles burst spectacularly, landing the Japanese economy into a severe recession. Now known famously as Japan’s lost decade, it was a period marked by economic stagnation, price deflation, a credit crunch, and a liquidity trap.

The BOJ attacked the situation with all the customary monetary and fiscal tools such as rate cuts and bond-buying. Unfortunately, these did not work as well as expected, and by 2002, the central bank realized that more unconventional tools were required. After 2002 it took measures such as taking stocks off banks’ balance sheets; buying corporate bonds, and then finally, in 2010, buying stock ETFs.

Except for an asset purchase program that includes stock ETFs, the Fed has already taken many of these steps after 2009.

Before it starts buying stock ETFs, the Fed might want to look at Japan’s experience with such a step.

Japan’s stock ETF buying program

Undeniably the program has proved to be a powerful backstop for Japan’s stock markets. Its Topix Index outperformed the S&P 500 index in March, with a total return loss of about 6%, compared to a 12% loss for the US index.

Further, in response to the coronavirus, the BOJ has boosted its program for buying stock ETFs to 12 trillion yen ($111 billion).

Unfortunately, over the long term, these measures by the BOJ have not been successful in reversing Japan’s economic fortunes. Spending in the economy has been stubbornly muted, and inflation well below targets.

Tiger by the tail

The BOJ now holds large chunks of Japan’s companies, raising issues of corporate governance. By one estimate, after the recent upward revision in buying targets, the BOJ could end up holding more equity than the Japanese state pension fund, the GPIF, by the end of this calendar year. The GPIF is currently the largest holder of domestic stocks.

The bigger question is how the BOJ will finally exit these holdings.

Managing the disinvestment, which is certain to severely impact the stock market, will be a tricky problem.

Till they are sold, the ETF assets would sit on the central bank’s balance sheet.

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