Financial asset overshooting and the disconnect with the real world

Are current financial markets irrational? Are equities and bonds in a financial bubble? These are some of the main questions to be discussed at the beginning of this year. There are many ways to address this question, but a continued theme is the disconnect between financial assets and the real world. We are not going to answer directly the initial questions; however, I will shed some light on the disconnect between the financial and real world from some key recent research on the topic. 

The model of a leading macro researcher Ricardo Caballero with the help of Alp Simsek provides some useful insights on this topic in their paper "Monetary Policy and Asset Price Overshooting: A Rationale for the Wall/Main Street Disconnect". They take the simple argument that the Fed wants to minimize the output gap that exists in the economy. This output gap will be affected by increases in wealth through financial prices, with a lag. If the Fed can push financial prices higher than normal, overshoot, then the gain in extra wealth will help reduce the output gap and provide a faster path to recovery. The words trickle down are not used, yet this is the direction of this work. Push up prices and the output gap can be closed. Push up prices early and the Fed can preempt output gaps. As long as the link between the financial and real world is lagged there will be a disconnect between the financial and real economy.  

Financial prices are something that the Fed can control immediately through their policy activities and raising these prices can support higher aggregate demand. The Fed is acting on multiple fronts but allowing for inflated asset prices is a clear policy choice priority. 

This conclusion should not be a surprise. It should be viewed as a tailwind for all asset allocation decisions. Because this works with a lag, Fed activity today can increase financial prices immediately under the hope that Main Street will be positively affected tomorrow. Higher asset prices with a weak economy can occur and be the result of policy action and not irrationality. The end result is a disconnect between Wall Street and Main Street. The trickle down affect has timing differences.