Working Paper: NBER ID: w30132
Authors: Ricardo J. Caballero; Alp Simsek
Abstract: We propose a model where the central bank’s (“the Fed’s”) interpretation of macroeconomic needs drives aggregate asset prices. The Fed affects macroeconomic activity with a lag by altering aggregate asset prices. Its objective is to align future aggregate demand and supply (in expectation). We reverse engineer the aggregate asset price that implements the Fed’s objective (“pystar”) and derive several implications: (i) the Fed’s beliefs about future macroeconomic needs (aggregate demand and supply) drive aggregate asset prices, while standard financial forces determine relative asset prices; (ii) more precise news about future aggregate demand makes output less volatile but increases asset price volatility; (iii) with aggregate demand inertia, the Fed overshoots asset prices in response to current output gaps; (iv) inflation is negatively correlated with aggregate asset prices, regardless of its source (aggregate demand or supply); and (v) belief disagreements between the central bank and the market generate a policy risk premium and potential “behind-the-curve” asset price dynamics.
Keywords: Monetary Policy; Asset Pricing; Financial Markets; Macroeconomic Stability
JEL Codes: E32; E43; E44; E52; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Fed's beliefs about future macroeconomic needs (E52) | aggregate asset prices (G19) |
| Fed's beliefs about future macroeconomic needs (E52) | interest rate adjustments (E43) |
| interest rate adjustments (E43) | aggregate asset prices (G19) |
| improved forecasting ability (C53) | asset price volatility (G19) |
| inflation (E31) | aggregate asset prices (G19) |
| belief disagreements between the Fed and the market (E52) | policy risk premium (G22) |
| policy risk premium (G22) | asset prices (G19) |