Liquidity, Term Spreads and Monetary Policy

Economics

Further details

The slope of the yield curve and the term spread have important implications for macroeconomic outcomes being amongst the key variables in predicting output growth (Estrella and Hardouvelis (1991)). We propose a model that delivers endogenous variations in term spread driven primarily by changes in banks’ expected profitability and their appetite to bear the risk of maturity transformation. We show that fluctuations of the future profitability of banks portfolios affect their ability to cover for any liquidity shortage and hence affect the premium they require to carry maturity risk. During a boom, profitability is increasing and hence spreads are low, while during a recession profitability is decreasing and hence spreads are high, in accordance with the cyclical properties of term spreads in the data. We also document empirical evidence showing the relevance of financial business profitability in explaining real output growth and the linkages between yield spreads and expected profitability. Finally, we use the model to look at monetary policy and show that allowing banks to sell long term assets to the Central Bank after a liquidity shock leads to a sharp decrease in long term rates and term spreads. Furthermore, such interventions have significant impact on long term investment, decreasing the amplitude of output responses after a liquidity shock. The short term rate does not need to be decreased as much and inflation turns out to be much higher than if no QE
interventions were done.