Abstract:
We examine the mutual fund market, focusing on its role in the transmission of monetary policy and its impact on asset market liquidity. Utilizing daily data on mutual fund flows in Israel, we observe that in response to contractionary monetary policy of one percentage point, mutual fund holders—which are predominantly households—reduce their investments in corporate and government bonds and equity funds by approximately 6-10% of the funds' assets, over about a month after the change. This reaction is accompanied by an expansion of money market funds, indicating a shift by retail investors from higher-risk to lower-risk assets. This finding is supported by indications of a parallel increase of Institutional investors’ holdings of higher-risk assets. Concurrently, we note a decrease in market liquidity of the underlying assets in response to the monetary tightening. Our findings suggest that the adjustments in asset portfolios through changes in mutual fund flows only partially explain the decline in liquidity. Unlike the strong and immediate reactions observed during real shocks such as the COVID crisis, responses to changes in monetary policy are moderate and gradual, posing less significant risks to market liquidity.