LIQUIDITY ANALYSIS. A COMMENT ON VOLATILITY & LIQUIDITY
. Bill Luby. "Volatility and Liquidity: A First Look", Vix and More

Bill Luby, who was kind enough to mention my blog in a recent post, encourages "any lurking monetarists and others with thoughts on liquidity and volatility to chime in". Here are some quick thoughts. Reading through Fed governor Kevin Warsh's excellent piece on Market Liquidity, it appears that the Federal Reserve does indeed see a link between volatility and liquidity:

Researchers have documented the so-called "Great Moderation" in which the U.S. economy has achieved a marked reduction in the volatility of both real gross domestic product (GDP) and core inflation over the past twenty years or so. In theory, reduced volatility, if perceived to be persistent, can support higher asset valuations--and lower risk premiums--as investors require less compensation for risks about expected growth and inflation ... Others have pointed to the low levels of stock market volatility in recent months as indicative of pressures from excess liquidity [1].

Thus, the "Great Moderation" of the business cycle —for which the VIX index can be seen as a proxy— expands the supply of loanable resources at every level of the interest rate. This, in my view, is the key link between volatility and liquidity. There is no need to dig deep into M2 or M3 [2].

[1] Fed vice-chairman Donald Kohn is a bit more skeptical: "... the relationship between financial market volatility and the volatility of macroeconomic variables such as GDP is not well understood".

[2] M2 and the now-defunct M3 measures are not liquidity measures. Says Warsh: "I doubt, however, that traditional monetary aggregates can adequately capture the form and structure of liquidity many observe in the financial markets today". See also my comment to Bill's post.