Wednesday, March 7, 2007

. Kevin Warsh. "Market Liquidity: Definitions and Implications", remarks at the Institute of International Bankers Annual Washington Conference, Washington, D.C. March 5, 2007.

"Liquidity is confidence", says Fed Governor Kevin M. Warsh. Now, that's a statement. Warsh's speech is worth reading, because it provides an attempt at defining global liquidity in more than just monetary terms. In fact, Warsh's argument is based on a "loanable funds theory of interest-rate determination" (*). This is much simpler than it sounds: financial innovation, he implies, leads to an increase in the supply of loanable funds ― and thus to a lower cost of capital across the board.

Warsh is thus an unabashed liquidity bull. The conventional definition of liquidity ―in purely monetary terms― no longer holds: "Instead, market observers are more likely to be referring to liquidity in broader terms, incorporating notions of credit availability, fund flows, asset prices, and leverage".

As to the yield curve, its days as a recession predictor are all but over: "Thus, to the extent that low long-term Treasury yields and the negative slope of the yield curve reflects a lower term premium, rather than a lower expected short rate, it is less likely to signal future economic weakness". Interesting ―and important― stuff.

(*) Frank Jones & Benjamin Wolkowitz. "The Determinants of Interest Rates on Fixed-Income Securities", in Frank J. Fabozzi (ed.). The Handbook of Fixed Income Securities (Homewood, Ill., 1991).

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