Liability-driven investors and monetary transmission

The ability of monetary policy to influence the term structure of interest rates and the macroeconomy depends on the extent to which financial market participants prefer to hold bonds of different maturities. We embed microfounded preferred-habitat demand into a New Keynesian framework with an arbitrage-free term structure. The source of preferred-habitat demand is a pension fund that issues annuities and adopts a liability-driven investment strategy to immunise its balance sheet against duration risk. This behaviour generates a liability-driven demand for bonds that is upward-sloping in prices and downward-sloping in yields. A recruitment channel emerges, whereby the reaction of long-term interest rates to conventional and unconventional monetary policies is amplified because of complementary changes in term premia induced by liability-driven demand. The enhanced monetary transmission extends to inflation and output in general equilibrium.