DP14830 Monetary Policy with Opinionated Markets

Author(s): Ricardo Caballero, Alp Simsek
Publication Date: May 2020
Keyword(s): asset prices, confident belief disagreement, data sensitivity, fed funds forward curve, learning, macro announcements, monetary policy, signaling, the Fed's dot plot, volatility and risk premium
JEL(s): E00, E12, E21, E32, E43, E44, G11, G12
Programme Areas: Financial Economics, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14830

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.