Monetary Policy with Opinionated Markets
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, 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 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.

Link to paper: www.dropbox.com/s/zs6ymzjg0vtszmq/opinionated_public.pdf?dl=0
Date: 9 February 2021, 13:00 (Tuesday, 4th week, Hilary 2021)
Venue: Held on Zoom
Speaker: Alp Simsek (Massachusetts Institute of Technology)
Organising department: Department of Economics
Part of: Macroeconomics Seminar
Booking required?: Not required
Audience: Members of the University only
Editor: Melis Clark