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The liquidity state dependence of monetary policy transmission

Author

Listed:
  • Oliver Ashtari-Tafti
  • Rodrigo Guimaraes
  • Gabor Pinter
  • Jean-Charles Wijnandts

Abstract

We show that monetary policy shocks move long-term government bond yields only when market liquidity is high and arbitrageurs are well capitalized. This liquidity state dependence operates entirely through real term premia, not expectations. Using novel transaction-level data on the US Treasury market, we find that arbitrageurs trade about 40% more duration during FOMC meetings in high-liquidity periods. We propose ways of enriching standard term-structure models to rationalize our evidence that constraints on arbitrage capital suppress transmission. The results introduce new empirical moments for theories of limits to arbitrage, and underscore the role of liquidity conditions in shaping the effectiveness of conventional monetary policy.

Suggested Citation

  • Oliver Ashtari-Tafti & Rodrigo Guimaraes & Gabor Pinter & Jean-Charles Wijnandts, 2025. "The liquidity state dependence of monetary policy transmission," BIS Working Papers 1289, Bank for International Settlements.
    • Handle: RePEc:bis:biswps:1289
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    Keywords

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    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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