The liquidity state dependence of monetary policy transmission

Oliver Ashtari-Tafti, Rodrigo Guimaraes, Gabor Pinter and Jean-Charles Wijnandts

No 1289, BIS Working Papers from Bank for International Settlements

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.

Keywords: monetary policy; long-term real rates; limited arbitrage; segmented markets (search for similar items in EconPapers)
JEL-codes: E43 E52 E58 (search for similar items in EconPapers)
Date: 2025-09
New Economics Papers: this item is included in nep-mac and nep-mon
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Related works:
Working Paper: The liquidity state-dependence of monetary policy transmission (2023)
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Persistent link: https://EconPapers.repec.org/RePEc:bis:biswps:1289

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