Discussion Paper Details

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Title: Monetary Policy and Asset Price Overshooting: A Rationale for the Wall/Main Street Disconnect

Author(s): Ricardo Caballero and Alp Simsek

Publication Date: August 2020

Keyword(s): asset prices, COVID-19, Macroeconomic news, market-bond portfolio, monetary policy, Output gap, Overshooting, Phillips curve, QE/LSAPs and Wall/Main Street disconnect

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

Abstract: We analyze optimal monetary policy when asset prices influence aggregate demand with a lag. In this environment, when there is a current or anticipated output gap, the central bank optimally overshoots asset prices (i.e., significantly reduces discount rates to increase asset prices). Asset price overshooting leads to a temporary disconnect between the performance of financial markets and the real economy, but it also accelerates the recovery. A more intense overshooting policy weakens the relationship between inflation and the output gap (i.e., it flattens the Phillips curve). We quantify the policy-induced overshooting through risk-free rates in the Covid-19 recession and find that actual overshooting significantly exceeded the overshooting implied by a Taylor rule benchmark. Our calibrated model suggests this additional overshooting substantially accelerated the recovery. Finally, we show that policy-induced overshooting, along with monetary policy constraints, can shed light on the cyclical variation in the response of asset prices to macroeconomic news.

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Bibliographic Reference

Caballero, R and Simsek, A. 2020. 'Monetary Policy and Asset Price Overshooting: A Rationale for the Wall/Main Street Disconnect'. London, Centre for Economic Policy Research.