The Term Structure of Liquidity Premium
58 Pages Posted: 7 Nov 2019 Last revised: 23 Mar 2021
Date Written: March 23, 2021
We analyze the term structure of Treasury liquidity premium (LP). Through a model where illiquidity shocks are alleviated by holding Treasuries, we show that LP term structure is shaped by expectations of future market liquidity, liquidity term premium, and Treasury supply. As predicted, the LP term structure is downward-sloping in recessions but upward-sloping in booms, and forward LP predicts future LP and market liquidity. Furthermore, LP is quantitatively important for monetary policy pass-through: LP dampens the pass-through of interest rate policy yet strengthens the pass-through of quantitative easings. We also use LP to infer the term structure of Treasury safety premium.
Keywords: Liquidity Premium, Term Structure, Monetary Policy
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