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Stock Market Liquidity, Monetary Policy and the Business Cycle

Working Paper
Markus Leippold, University of Zurich; Swiss Finance Institute; Vincent Wolff, University of Zurich - Department of Banking and Finance
Swiss Finance Institute Research Paper No. 22-93, 18 November 2022

Abstract

Næs, Skjeltorp, and Ødegaard (2011) provide empirical evidence that stock market liquidity contains leading information about future economic activity. Their result suggests a rebalancing of small, increasingly illiquid to large stocks in recession times, an expression of “flight-to-quality”. We show that the relationship no longer holds due to the Fed’s accommodative monetary policy to buoy stock markets in crisis starting in the 1990s. Moreover, we document that liquidity dry-ups in small stocks no longer coincide with recessions. The Fed’s interventions mute the systematic link between monetary conditions and aggregate stock market liquidity’s well-established business cycle component.