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Title: Monetary Policy with Opinionated Markets

Author(s): Ricardo Caballero and Alp Simsek

Publication Date: May 2020

Keyword(s): aggregate demand shocks, belief shocks, communication, confident disagreement, forward curve, Gradualism, monetary policy and shocks, taper tantrum, the Fed's dot plot and the term structure of interest rates

Programme Area(s): Financial Economics and Monetary Economics and Fluctuations

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, together with learning, 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, and analyze their impact on forward interest rates and economic activity. Tantrum shocks are the most damaging, as they arise when the Fed fails to forecast the forward rates' reaction. These shocks motivate additional gradualism as well as communication policies that reveal the Fed's belief, not to persuade the market (which is opinionated) but to prevent a misinterpretation of the Fed's belief. Finally, we also find that disagreements affect inflation and create a policy trade-off between stabilizing output and inflation.

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Bibliographic Reference

Caballero, R and Simsek, A. 2020. 'Monetary Policy with Opinionated Markets'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=14830