The key issue is the regulation of the liquidity of all financial markets, and not just that of the banking system
The end of Quantitative Easing, and the rise in inflation since 2022 has focused attention once more on the effectiveness of monetary policy in controlling inflation. This question is framed in a way that brooks no contrary evidence: If inflation continues above target, or rises, then this is taken to mean that monetary policy is still too loose, and interest rates may need to be raised further; if inflation falls below the target level then monetary ‘tightening’ has been excessive, and may need to be loosened by a reduction in policy rates of interest.
This common view of the dilemma facing monetary policy-makers overlooks one important aspect of monetary policy, namely the effect of this policy on the liquidity of the financial system. This aspect matters for two important reasons. First of all the liquidity of the financial system determines the profile of long-term interest rates, and those rates are a crucial aspect of the monetary transmission mechanism that is supposed to make monetary policy effective in controlling inflation.
Secondly, we know that if liquidity in the financial system is reduced below a certain level, then even routine sales of long-term securities may cause a financial crisis. It was this illiquidity that lay behind the dot-com crash of 2001-2002, and subsequently the collateralised debt obligations crash of 2007-2008. By flooding the financial system with liquidity, Quantitative Easing stabilised the markets. But that is now coming to an end.
My new INET working paper explains how liquidity in the financial system rises and falls with different financing arrangements, and the mechanisms by which monetary policy influences that liquidity. It is not just all about liquidity!
