Liquidity impairment harms policy transmission – BIS paper

Liquidity impairment harms the transmission of monetary policy, research from the Bank for International Settlements argues.

The working paper, published on September 9, argues that market functioning “is not merely a financial stability concern but a central determinant of the efficacy of conventional monetary policy”.

The authors – Oliver Ashtari-Tafti, Rodrigo Guimaraes, Gabor Pinter and Jean-Charles Wijnandts – examine aggregate yield data from the US Treasuries market. They argue that bond purchase programmes, such as quantitative easing, may be more potent during periods of market stress and when arbitrage capital is constrained.

They add that monetary policy has a greater pass-through when arbitrageurs are well-capitalised and markets are more liquid.

“Long-term yields react to policy rate surprises significantly more when market liquidity is high,” they write. “These effects are driven by changes in real term premia and persist for up to three months after the policy announcement.”

The authors say their findings add a new dimension to policy transmission, which they refer to as “liquidity state dependence”.

“Monetary transmission is a joint product of policy, market structure, and investor composition,” they say. “Accounting for this interaction is essential for understanding when and why monetary policy shocks have strong effects on long-term interest rates.”