Essays on market liquidity and monetary policy

Abstract

The first essay examines the ability of financial market illiquidity to predict key Australian and U.S. macroeconomic variables. I analyse whether illiquidity's predictive ability is state-contingent, drawing on recent theoretical work on the potential for a state-contingent relationship. Using a Markov regime switching model, I uncover strong evidence that the predictive power of illiquidity is state-contingent, with much higher predictability in states associated with historical periods of economic and financial stress. Furthermore, economic growth forecasts from Markov regime switching models that include market liquidity in the set of predictor variables are statistically better than forecasts from Markov switching models that exclude market liquidity.

Gorton and Metrick (2010, 2011) argue that a run on the repo market played a key role in the collapse of shadow banks, while Krishnamurthy, Nagel and Orlov (2011) argue the collapse was chiefly due to a run on asset-backed commercial paper (ABCP). In order to assess the validity of these arguments, the second essay empirically examines the link between market liquidity and funding liquidity in various U.S corporate bond markets. Over the entire 2005-09 sample period, I find weak evidence of predictive ability among these variables. Where significant, repos are found to have higher predictive ability than ABCP. In addition, unsecured funding liquidity is found to have as much predictive ability as repos. These findings partially support Gorton and Metrick (2010, 2011), but do not support Krishnamurthy et al. (2011). I also find that the relationship between market liquidity and funding liquidity is state-contingent, a finding which supports the theoretical literature on the existence of nonlinear, regime-switching behaviour.

The final essay assesses the impact, on credit market spreads, of the various unconventional policies introduced by the U.S. Federal Reserve, between mid-2007 and early 2009. I also examine the impact of fiscal policies announced during this period, as well as the stance of conventional monetary policy. I find that fiscal policy announcements exerted a significant and destabilising influence on market spreads. Furthermore, while the multitude of unconventional monetary policy initiatives were effective in reducing market spreads, the efficacy of these policies was undermined by the Federal Reserve's inability to achieve its macroeconomic objectives.