DP15163 Monetary Policy and Asset Price Overshooting: A Rationale for the Wall/Main Street Disconnect

Author(s): Ricardo Caballero, Alp Simsek
Publication Date: August 2020
Date Revised: July 2021
Keyword(s): asset prices, COVID-19, Macroeconomic news, market-bond portfolio, monetary policy, Output gap, Overshooting, Phillips curve, QE/LSAPs, Wall/Main Street disconnect
JEL(s): E21, E32, E43, E44, E52, G12
Programme Areas: Financial Economics, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15163

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.