Dudley Says Fed Tightening May Shed Light on Liquidity Situation

  • Evidence that bond market liquidity has dried up mixed at best
  • Some signs that liquidity risk may have increased, Dudley says

The U.S. central bank’s massive purchases of bonds that began in 2008 to support the economy may be obscuring metrics used to measure bond market liquidity, said New York Federal Reserve President William C. Dudley.

“Unconventional monetary policy may have affected recent measures of liquidity in ways that could make it more difficult to clearly discern any potential changes,” Dudley said Wednesday in remarks prepared for a speech in New York. “To the extent that this may be the case, then a clearer picture on liquidity conditions may only emerge as monetary policy is normalized."

The Fed started its unprecedented bond purchases to reduce longer-term borrowing costs as it cut the benchmark federal funds rate almost to zero. It bought Treasuries and mortgage debt in three waves of so-called quantitative easing that ended in October 2014, amassing a $4.2 trillion portfolio in the process.

Dudley, speaking at a forum on market liquidity, said common metrics like bid-ask spreads, order book depth, and the price impact of trades showed only “limited evidence pointing to a reduction in the average levels of liquidity” relative to before the financial crisis. But he also cautioned that liquidity risk -- the chance that it could suddenly dry up at some point in the future -- may have risen.

“Over the last two years Treasury liquidity risk has moved higher and relative to the pre-crisis period is currently somewhat elevated,” he said.

The New York Fed chief, who did not comment about the outlook for the U.S. economy or monetary policy in his prepared remarks, expressed skepticism that regulatory changes made in the wake of the crisis were reducing liquidity in a significant way.

“We have a financial system that is much more resilient, and the available evidence suggests that this transformation has not resulted in any significant erosion in market liquidity,” he said. “But if there are adjustments to regulation that could improve liquidity provision without increasing financial stability risks, we should be open to considering such changes.”

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