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

Ricardo J. Caballero, Alp Simsek

NBER Working Paper No. 27712
Issued in August 2020
NBER Program(s):Asset Pricing, Economic Fluctuations and Growth, Monetary Economics

We analyze optimal monetary policy when asset prices influence aggregate demand with a lag (as is well documented). In this context, as long as the central bank's main objective is to minimize the output gap, the central bank optimally induces asset price overshooting in response to the emergence of a negative output gap. In fact, even if there is no output gap in the present but the central bank anticipates a weak recovery dragged down by insufficient demand, the optimal policy is to preemptively support asset prices today. This support is stronger if the acute phase of the recession is expected to be short lived. These dynamic aspects of optimal policy give rise to potentially large temporary gaps between the performance of financial markets and the real economy. One vivid example of this situation is the wide disconnect between the main stock market indices and the state of the real economy in the U.S. following the Fed's powerful response to the Covid-19 shock.

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Document Object Identifier (DOI): 10.3386/w27712