Stock liquidity and the Taylor rule

• Output gap and inflation impact stock liquidity and commonality in liquidity.
• An increase in the Taylor rule fundamentals lowers stock liquidity.
• An increase in the Taylor rule fundamentals increases commonality in liquidity.
• This effect is larger for stocks with low market capitalization and low liquidity.
• Our evidence supports that funding liquidity impacts stock market liquidity.

This paper examines how stock market liquidity and commonality in liquidity are impacted by real-time output gap and inflation, as these macroeconomic variables have been shown to be the main drivers of monetary policy according to the Taylor rule. We show that an increase in the output gap and inflation lowers stock liquidity and increases commonality in liquidity, since it points to a contractionary monetary policy and is likely to lead to a decline in the liquidity providers' funding liquidity. This effect is larger for stocks with low market capitalization and low liquidity.