Monetary Policy with Opinionated Markets

50 Pages Posted: 22 Jun 2020

See all articles by Ricardo J. Caballero

Ricardo J. Caballero

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER)

Alp Simsek

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 3 versions of this paper

Date Written: May 28, 2020

Abstract

Central banks (the Fed) and markets (the market) often disagree about the path of interest rates. We develop a model that explains this disagreement and study its implications for monetary policy and asset prices. We assume that the Fed and the market disagree about expected aggregate demand. Moreover, agents learn from data but not from each other — they are opinionated and information is fully symmetric. We then show that disagreements about future demand, together with learning, translate into disagreements about future interest rates. Moreover, these disagreements shape optimal monetary policy, especially when they are entrenched. The market perceives monetary policy "mistakes" and the Fed partially accommodates the market's view to mitigate the financial market fallout from perceived "mistakes." We also show that differences in the speed at which the Fed and the market react to the data — heterogeneous data sensitivity — matters for asset prices and interest rates. With heterogeneous data sensitivity, every macroeconomic shock has an embedded monetary policy "mistake" shock. When the Fed is more (less) data sensitive, the anticipation of these mistakes dampen (amplify) the impact of macroeconomic shocks on asset prices.

Keywords: Monetary Policy, Confident Belief Disagreement, Learning, Signaling, Monetary Policy Shocks, Asset Prices, Aggregate Demand Shocks, the Fed’s Dot Plot, Fed Funds Forward Curve, Macro Announcements, Volatility and Risk Premium, Risk Sensitivity

JEL Classification: E00, E12, E21, E32, E43, E44, G11, G12

Suggested Citation

Caballero, Ricardo J. and Simsek, Alp, Monetary Policy with Opinionated Markets (May 28, 2020). Available at SSRN: https://ssrn.com/abstract=3612949 or http://dx.doi.org/10.2139/ssrn.3612949

Ricardo J. Caballero (Contact Author)

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Alp Simsek

Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

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