The Federal Reserve’s Effect on Stock Market Liquidity

The business cycle is no longer reflected in changes in stock market liquidity since the Greenspan era.

Investing Pioneer  – 2/8/2023 – 1:38 PM EST

The presence of a central bank has significant implications for the cycle of liquidity, and how that corresponds to the business cycle. From 1947 to 2008, a strong correlation between stock market liquidity and the business cycle was documented, according to a 2011 study published in the Journal of Finance (Leippold et. al, November 25, 2022).

Starting in the 1990s however, the accommodative policy by the Federal Reserve under Greenspan disconnected this association between the standard business cycle and stock market liquidity. This means that recessions in the business cycle, since the 1990s, no longer are significantly associated with aggregate stock market liquidity changes.

(Leippold et al, November 25, 2022)

Indeed, this relationship between stock market liquidity and the business cycle is influenced by the interventive behavior of the Fed.

In short, stock market liquidity no longer rises and falls with swings in the economy, as it did before.

In a paper released in late November of 2022 entitled “Stock Market Liquidity, Monetary Policy and the Business Cycle”, it was stated, “market-wide liquidity increases following expansive monetary policy, which is especially beneficial for small/illiquid securities” (according to a 2010 study by Jensen Moorman).

Typically, one would expect liquidity to worsen during an economic recession and improve when the economy recovers. However, the 2022 paper states that from 1994 to 2022, aggregate liquidity was in fact stable and unaffected by the business cycle.

It is said that since 1994, the stock market has become an important direct marker that the Federal Reserve follows, and issues monetary response, through the use of federal funds rates reductions, forward guidance, and Quantitative Easing programs (2022, Leippold et al.)

This means that monetary expansion does not always necessarily lead to an increase in liquidity as it takes place during drawdowns muting a net positive effect relative to the period prior (2022, Leippold et al.)

The paper effectively states that before, the federal funds rate was made in accordance with the business cycle, now, that is less so the case.

Leippold, Markus and Wolff, Vincent, Stock Market Liquidity, Monetary Policy and the Business Cycle (November 25, 2022). Swiss Finance Institute Research Paper No. 22-93, Available at SSRN: https://ssrn.com/abstract=4286698 or http://dx.doi.org/10.2139/ssrn.4286698ve