The Equity Premium, Long-Run Risks to R-Star, and Asymmetric Optimal Monetary Policy

Abstract

With the Federal Reserve undergoing a serious review of its strategy, this paper provides a timely analysis that focuses on longer-run themes and monetary policy's potential influence. If we take the stance that asset prices indicate a high cost of exposure to long-run risks, this has very interesting implications for monetary policy that ripple through a surprisingly broad set of dimensions. There is an intuitive result that a Ramsey planner might wish to attenuate long-run risks (a key contributor to shifts in r-star). Less intuitively, I show that a Ramsey policymaker will induce a tolerance for skewness and a higher average inflation rate than is typically advocated in the literature. A variety of factors contribute to these results. First, deep non-linearities in the model entail that the policymaker behaves asymmetrically in its countercyclical policies. Second, the presence of capital generates longer-run effects (hysteresis) and additional tradeoffs, which implies that "countercyclical" in this model takes on a lower frequency theme. And third, imperfect competition leads to the pursuit of a higher average inflation rate to offset the related welfare costs.