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

Abstract

We analyze optimal monetary policy and its implications for asset prices when aggregate demand has inertia. If there is a negative output gap, the central bank optimally overshoots aggregate asset prices (above their steady-state levels consistent with current potential output). Overshooting leads to a temporary disconnect between the performance of financial markets and the real economy, but accelerates the recovery. When there is a lower bound constraint on the discount rate, good macroeconomic news is better news for asset prices when the output gap is more negative. Finally, we document that during the COVID-19 recovery, the policy-induced overshooting was large.