Staff Working Paper No. 1,045
By Oliver Ashtari-Tafti, Rodrigo Guimaraes, Gábor Pintér and Jean-Charles Wijnandts
We show that monetary policy shocks move long-term government bond yields only when market liquidity is high and arbitrageurs are well capitalised. This liquidity state dependence operates entirely through real term premia, not expectations. Using novel transaction‑level data on the US treasury market, we find that arbitrageurs trade about 40% more duration during FOMC meetings in high‑liquidity periods. We propose ways of enriching standard term‑structure models to rationalise our evidence that constraints on arbitrage capital suppress transmission. The results introduce new empirical moments for theories of limits to arbitrage, and underscore the role of liquidity conditions in shaping the effectiveness of conventional monetary policy.
This version was updated in August 2025.
The liquidity state dependence of monetary policy transmission
