Central bank QE: How far will risk taking go?
The likelihood that the Fed or the ECB will buy shares seems very low to us. It would take another major crisis to make them take this leap.
After several years of existence, Quantitative Easing (QE) has established itself as the main tool for steering monetary policy in many central banks. This is a natural development because conventional tools no longer really have room for manoeuvre: Policy rates at major central banks are at zero or even negative and representatives of these institutions have announced they want to keep rates at these levels for a long time.
What is QE?
Central banks drive short term interest rates thanks to their policy rates. However, they have little impact on medium and long-term interest rates. QE is an asset purchase programme. By buying bonds, the central bank is pushing up the prices of these assets and thus lowering interest rates over the medium to long term. In this way, central banks guarantee lower financing costs to the real economy (businesses and households). At the same time, governments benefit from more favourable terms on their debt. QE thus improves the solvency of the most indebted states. Finally, in crises, buyers become scarcer and liquidity dries up. These effects are mitigated through QE as central banks remain buyers, allowing the market to operate and economic players to refinance themselves on more ‘normal’ terms. This is particularly relevant for corporate bonds.
What limits apply to QE?
As crises unfolded, central banks expanded the scope of QE buying categories. First confined to risk-free assets (sovereign bonds), it then included risky assets such as corporate bonds. The ECB has been buying Investment Grade corporate bonds (the highest rated, as opposed to High Yield) since March 2016. The US Federal Reserve has gone further and since the health crisis it has been buying High Yield ETFs alongside Investment Grade corporate bonds. A debate then opened: Can it do even more on the risk scale and also buy equities as the central banks of Japan and Switzerland do?
The examples of Japan and Switzerland
The central banks of these countries have been buying equities for several years, but for different reasons. Japan's central bank has paved the way, at the request of the government, to counter deflation. One idea was to create a wealth effect, which would then have had beneficial effects on consumption, growth and inflation. In Switzerland, the aim of general equity purchasing is to stem the appreciation of the Swiss franc. The United States and the eurozone are more like Japan. After almost ten years of equity purchases, Japan's central bank has become a very important shareholder. It held about 80% of the equity ETF market at the end of 2019. However, its policy is not really a success. The bank participated in pushing up the equity market, but it never returned to its record high. Most importantly, the central bank failed to generate inflation or get anywhere near to its 2% target.
The implications of QE being extended to risk assets
The ideological debate. In the US, a member of the Federal Reserve suggested that it should expand the scope of its QE purchase categories. Some interpreted it as the possibility that the Federal Reserve might buy equities. However, US law prohibits it. Congress would therefore have to agree beforehand. The political debate would be intense. The Federal Reserve could be seen as an instrument for the benefit of Wall Street and not as an institution looking out for all Americans, not all of whom have the financial means to hold a portfolio of equities. The Federal Reserve has been justifying its decisions for years on the basis of their impact on the real economy, particularly the fight against unemployment.
The distortion of the markets. This is a criticism often levelled at the central bank of Japan. When an institution with theoretically unlimited financial capacity intervenes in markets without worrying about asset prices, then this creates price distortions. Risk assets are no longer valued at their ‘fair’ value.
Risk to capital. Japan's central bank's equity portfolio posted almost USD 30 billion in unrealized losses due to the market plunge in March. The treatment of losses differs across central banks. Some are forced to be recapitalised by their shareholder (the government), others not. Generally, losses are absorbed by past profits that have been recorded in reserves, revaluation accounting and other special purpose provision accounting. Any remaining losses are then charged against future profitable years.
Exit strategy? Buying risk assets can be a good short term solution to stabilise markets in the event of another crisis. However, once the crisis has passed, the central bank no longer has any reason to maintain its purchases of risk assets. Past experience shows that it is very difficult to get out of easy monetary policy, once applied, without destabilising markets and that it takes a long time. Unlike bonds, equities have no redemption date.
At this stage, the likelihood that the Federal Reserve or the ECB will expand their QE into risk assets seems very low to us. The usefulness would be relative given that markets have stabilised and even resumed their upward trend. It would take another major crisis for these central banks to consider making the leap, and at that point it would pose an ethical challenge as it could prioritise some parts of the population. The latest statements by the Federal Reserve governor suggest that the valuation of financial assets is a collateral consequence, not a monetary policy objective. The first priority for the ECB and the Fed is to keep yields low for a long time. Buying quality bonds seems to remain the most appropriate cost efficient tool for this.