2002 has been unusual, the most pressing determinant was not uncertainty about the profit potential of capital investment. 3 instead, corporate cash positions are explained more significantly by profits retained at foreign subsidiaries, and a sharper focus by investors and ratings agencies on companies ’ abilities to finance short - term liabilities internally. current sources of market liquidity let me discuss sources of liquidity of the u. s. financial markets. by my proposed definition, we must ask what forces have increased liquidity ( read : confidence ) in the united states over the course of the last couple of decades. i will turn, first, to two key drivers of liquidity : rapid financial innovation and strong economic performance. a third important source of liquidity – resulting from the excess savings of emerging - market economies and those with large commodity reserves – has also found its way to the united states in pursuit of high risk - adjusted returns. we must judge the extent to which each of these three liquidity drivers are structural or cyclical, more persistent or more temporary. understanding the sources of liquidity – and the causes thereof – should help inform judgments about “ new challenges for monetary policy, ” chairman alan greenspan, symposium sponsored by the federal reserve bank of kansas city, august 27, 1999. “ corporate cash and economic activity, ” governor kevin m. warsh, american enterprise institute, july 18, 2006. the level and direction of market liquidity. in so doing, we may better understand its implications for the economy and policymakers alike. first, liquidity is significantly higher than it would otherwise be due to the proliferation of financial products and innovation by financial providers. this extraordinary growth itself is made possible by remarkable improvements in risk - management techniques. hewing to my proposed definition, we could equally state that financial innovation has been made possible by high levels of confidence in the strength and integrity of our financial infrastructure, markets, and laws. moreover, remarkable competition among commercial banks, securities firms, and other credit intermediaries have helped expand access to – and lower the all - in - cost of – credit. interest rate risk and credit risk exposures are now more diversified. look no further than dramatic growth of the derivatives markets. in just the past four years, notional amounts outstanding of interest rate swaps and options tripled, and outstanding credit default swaps surged more than ten - fold. these products allow investors to hedge and unwind positions easily without having to transact in cash markets, expanding the participant

to occur when underlying fundamentals are solid. monetary policy is no less challenged by the level and prospects for liquidity. we policymakers must ask whether liquidity conditions are obscuring signals from financial asset prices that we would otherwise use to gauge the performance of the real economy. 9 liquidity conditions could, in theory, lead to lower - than - justified risk premiums that stimulate aggregate demand or otherwise generate excessive inflationary pressures. of course, inferences from market prices are always imprecise, because prices depend on expected growth, the variation surrounding that expected path, and investor risk aversion, none of which we can precisely observe. market liquidity may further confound the inference challenges. allow me to comment, nonetheless, on a few key indicators. look at the current configuration of treasury yields across the maturity spectrum. typically, investors require compensation for the greater exposure to interest rate risk from holding longer - term securities, leading to an upward - sloping yield curve. since about mid - 2006, the yield curve has been about flat to downward - sloping. currently, the two - year rate slightly exceeds the ten - year treasury rate, which stands just above 4 - 1 / 2 percent. a negatively sloped yield curve has, in the past, served as a reasonably good predictor of economic recessions. but, there are compelling reasons to suspect that level of liquidity is affecting the slope of the yield curve, and lessening its predictive power. the same factors that are contributing to liquidity – low uncertainty about inflation and output – are also driving down term premiums and, hence, long - term treasury yields. 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. high liquidity could also obscure some information we glean from corporate bond prices. what if the current level of liquidity caused lower risk premiums than could be justified by actual credit risks? might a misallocation of resources result? many commentators have pointed to the low spread of corporate yields relative to treasuries as a sign of investors “ reaching for yield ” due to perceived excess liquidity. risk spreads, however, appear less exceptional given the remarkable strength of the corporate sector. we can decompose risk spreads for corporate bonds into a series of forward spreads over a sequence of time periods. forward spreads include compensation investors