There Is No Stable Monetary Policy “Risk Channel”

Via Natixis' Patrick Artus,

In reality, central banks control only the prices of the assets they buy directly

When a central bank buys an asset directly (often government bonds), it drives up the price of this asset, the demand for which increases.

 

But the prices of the other asset classes increase only if the economic agents that have sold the first assets to the central bank use the money received to buy these other asset classes.

 

This transmission of increases in asset prices to all asset classes is therefore unstable, since it depends on the behaviour of investors and savers. Since 2012, we have seen that central banks’ purchases first led asset sellers to buy risky assets (equities, corporate bonds), whose prices rose. But in the recent period, the rise in risk aversion has turned them away from risky assets, whose prices have fallen, and they have invested the money received from the central bank in risk-free assets.

 

There is therefore no stable monetary policy "risk channel"; the only asset prices that are controlled by central banks in the longer run are those of the assets that central banks buy directly. This could in the future push central banks to buy riskier assets if they want to change their prices in a stable manner.

Central banks’ asset purchases have a direct impact on the prices of these assets

When a central bank buys financial assets, it increases demand for these assets, which directly drives up their prices.

This occurred with purchases of Treasuries and ABS in the United States (Charts 1A and B) and with government bonds in the United Kingdom and Japan (Charts 2A and B), and with the announcement of covered bond purchases in the euro zone (Chart 3).

But the impact of the central bank’s asset purchases on other asset classes is uncertain

The central bank buys assets (especially government bonds, Charts 1A, 2A and B above).

It pays by creating money (Chart 4).

The economic agents that sell assets to the central bank use this money to buy other assets. But they have a free choice: a quantitative easing policy will drive up the prices of the assets that economic agents choose to buy, not the prices of the others.

We also saw from 2011-2012 until the spring of 2014:

  • A tightening of credit spreads (Charts 5A and B, 6A and B);
  • A rise in the stock market (Charts 7A and B, 8A and B).

But investors’ risk aversion has risen since the spring of 2014, (Charts 9A and B): they no longer buy risky assets and the prices of these assets have corrected downwards, whereas long-term interest rates on risk-free government bonds have fallen sharply (Chart 3 above, Charts 10A and B).

The transmission of the rise in the prices of the assets the central bank buys directly to a rise in the prices of other assets is therefore unstable, since it depends on investors’ attitude and their risk aversion.

Conclusion: The risk channel is not robust

The "risk channel" is the mechanism through which the central bank’s monetary creation drives down risk premia.

 

We have seen that this mechanism is unstable: it functions only if economic agents use the money created by the central bank, in exchange for purchases of risk-free assets, to buy risky assets.

 

If their risk aversion rises, this mechanism disappears – and so does the risk channel. In that case, the only remaining possibility for the central bank is to buy risky assets directly if it wants to drive down their prices.

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via Zero Hedge http://ift.tt/1o6AqbK Tyler Durden

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