Stock Liquidity and the Taylor Rule

Abstract

Recent theoretical models have linked stock liquidity and commonality in liquidity to the market makers’ funding availability and financial constraints from liquidity supply side. This paper establishes the linkage between stock liquidity and real time macroeconomic variables through the Taylor rule, the monetary policy rule that Federal Reserve uses to determine federal funds rate. Tightness in the funding market as indicated by Taylor rule fundamentals changes the funding liquidity and financial constraints faced by market makers in the stock market, which will affect their ability and incentive to provide liquidity. We document evidence that Taylor rule fundamentals can influence stock liquidity at both the market and individual firm level. We show that a rise in the output gap and inflation lowers stock liquidity. Contemporaneous Taylor rule fundamentals also affect commonality in liquidity from the liquidity supply side. We find that when Taylor rule fundamentals indicate a tighter monetary policy, commonality in liquidity in the stock market intensifies. These results are robust to various measures of liquidity, output gap and specifications of the Taylor rule models. However, when commonality of liquidity is determined by contemporaneous federal funds rate from the liquidity demand side, the effect of the Taylor rule is not as strong as the wealth effect.