Monetary Policy with Opinionated Markets

72 Pages Posted: 3 Jun 2020 Last revised: 1 Mar 2021

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 2020

Abstract

Central banks (the Fed) and markets (the market) often disagree about the path of interest rates. We develop a model where these different views stem from disagreements between the Fed and the market about future aggregate demand. We then study the implications of these disagreements for monetary policy, the term structure of interest rates, and economic activity. In our model, agents learn from the data but not from each other---they are opinionated. In this context, the market perceives monetary policy "mistakes" and the Fed partially accommodates the market's view to mitigate the impact of perceived "mistakes" on output and inflation. The Fed plans to implement its own view gradually, as it expects the market to receive more information and move closer to the Fed's belief. Disagreements about future demand translate into disagreements about future interest rates. Disagreements also provide a microfoundation for monetary policy shocks: after a surprise policy announcement, the market (partially) learns the Fed's belief and the extent of future "mistaken" interest rate changes. We categorize these shocks into three groups: Fed belief shocks, market reaction shocks, and tantrum shocks. Tantrum shocks are the most damaging, as they arise when the Fed fails to forecast the forward rates' reaction. These shocks motivate gradualism and communication policies that reveal the Fed's belief, not to persuade the market (which is opinionated) but to prevent the market from misinterpreting the Fed's belief. Finally, we also find that disagreements affect inflation and create a policy trade-off between output and inflation stabilization akin to "cost-push" shocks.

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

Suggested Citation

Caballero, Ricardo J. and Simsek, Alp, Monetary Policy with Opinionated Markets (May 2020). CEPR Discussion Paper No. DP14830, Available at SSRN: https://ssrn.com/abstract=3615593

Ricardo J. Caballero (Contact Author)

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

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Alp Simsek

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

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