Fed foreshadowing from the Bank of Japan?

November 5, 2010, 9:08 PM UTC

In a grim preview of what Ben Bernanke may find himself advocating next year, the Bank of Japan this week started loading up on stocks and real estate investments.

Like the Federal Reserve, Japan’s central bank is trying to rouse a slumbering economy at a time when the typical tool of monetary policy, a cut in short-term interest rates, is not available. The BoJ’s basic discount rate hasn’t been above 1% since 1995, and the bank cut it last month to 0% in its latest effort to boost demand for goods and services.

Japan's unfriendly rate trend

As part of its umpteenth attempt to fend off the effects of falling prices known as deflation, the BoJ said last month it would buy the shares of exchange-traded funds, or ETFs, which are baskets of stocks that track the prices of things like market indexes.

It also set plans to buy J-REITs, the real estate investment trusts legalized a decade ago as the Japanese took another swing at cleaning up a banking sector beset with bad property loans, and corporate bonds.

The terms under which it will make the purchases were released Friday. Purchases will continue through 2011 under a $62 billion plan the bank announced in October.

So what does this have to do with the Fed? By setting out on another round of asset purchases, the Fed has embarked on a path that has could easily lead to its taking up something like the BoJ’s policies.

In normal times, the Fed conducts monetary policy by adjusting the money supply through purchases and sales of Treasury securities. But in its first round of quantitative easing, which ran for a year starting in March 2009, the Fed also purchased mortgage-backed securities and bonds issued by the government-sponsored mortgage companies Fannie Mae and Freddie Mac.

The Fed is expected to stick to purchases of Treasury securities with its second round of quantitative easing, whose launch was announced Wednesday. But skeptics of easy money, and there are many, believe QE2, as it’s known, will fail to revive the domestic economy while adding to the considerable hot money problems being shouldered by governments around the globe.

Yet with the U.S. government gridlocked and the Fed saying it’s legally bound to bring down unemployment as long as it doesn’t lead to an uptick in inflation, few doubt the Fed’s largesse will end at $600 billion of new Treasury purchases — even if there’s no evidence the policy is working.

“When the Fed realises that QE2 isn’t working it will have two choices: Admit this is a lost cause and halt its purcahses or increase the size of its purchases,” writes Paul Ashworth at Capital Economics. “We suspect the Fed would double-down rather than fold.”

So how might the Fed double down? Though there are some legal issues that will have to be negotiated with Congress – the Fed now isn’t technically supposed to be buying riskier assets — there are plenty of options, ranging from expanded funding of small business loans (boosts hiring) to purchases of municipal bonds (helps fund strapped local governments) to, um, buying stocks.

“The Fed can do whatever it wants,” says Euro Pacific Capital economist Michael Pento.

So, why stocks? Because, UCLA economist Roger Farmer has argued:

To prevent a second recession, we must prevent a collapse of private wealth.

One policy to accomplish this would be to restore the program of quantitative easing through Fed purchases of long bonds.

A better policy would be for the Fed to buy shares in an index fund like the Russell 5000 to prevent the stock market from collapsing in a self-fulfilling spiral.

That, we can all agree, would best be avoided. Would it actually work? Well, there’s only one way to find out, and we will be very much on course for doing so if Friday’s happy jobs surprise isn’t repeated in each of the next 11 months.