Disagreement About Monetary Policy

Abstract

This paper studies the causes and consequences of belief differences between markets and central banks about monetary policy over the business cycle. Using US data since 1995, I document that “bad macroeconomic news” in public signals systematically predicts market over-estimation of interest rates, excessive market optimism about employment, and delayed correction of these forecasts. In a stylized model that can accommodate belief disagreements via three leading mechanisms—asymmetries between the market and central bank in their signals about fundamentals, beliefs about the monetary rule, and confidence in public signals—I show that significantly different confidence in public signals is necessary to explain the facts. The market's relative under-reaction to public signals substantially dampens the response of market beliefs to fundamentals, while the central bank's signaling through policy or the “information effect” has almost no role.