Economics Seminar - Risk Premia, Subjective Beliefs, and Forward Guidance

How can researchers identify monetary shocks and their causal impacts when (i) agents may possess subjective beliefs and (ii) monetary authorities manage current and future interest rates (e.g., forward guidance)? Assuming rational expectations or risk-neutrality trivially enables identification. Without those assumptions, identification of monetary shocks from asset prices hinges on a “Long-Run Neutrality” condition, roughly meaning policy does not affect the compensation for permanent risks. We construct a non-parametric test of the Long-Run Neutrality condition, related to the literature on FOMC announcement effects, and argue that it is violated in the data. Finally, we present some example models in which the Long-Run Neutrality condition is violated, illustrating how this condition is generally distinct from conventional notions of monetary neutrality.