Questioning the Credibility of Central Banks
Since the financial crisis, the central banks have been trying to maintain its credibility. The credibility has evolved differently depending on the macroeconomic policy mix chosen by the country.
How can credibility be measured?
The way to measure credibility is by looking at how central banks accomplish their targets. If the market expectations satisfy the central banks’ inflation target, then we say that the central banks are credible. The closer the two variables — inflation expectation and inflation target — move together over time, the more credible a central bank is. To establish credibility, the central banks have to build a successful history of hitting the inflation target. Conversely, continual failures would cause people to lose faith in a central bank’ ability to reach its target.
Benefits of Inflation Targets
- Credibility / Market Expectations: When the central bank commits to keeping the 2% inflation target, people will have inflation expectations around the target. If there’s no inflation target, there would be lots of uncertainty in the market. For instance, people expect inflation would be higher than 2%, which leads to workers demanding higher wage, and firms increasing their selling prices to consumer due to an increase in their cost of inputs.
- Reduce Uncertainty: assume inflation is rocketing to a high level and there’s a lot of price variabilities. This condition would increase uncertainty in business confidence to invest and consumer confidence to consume.
Looking at the US
- After the financial crisis, people have lost their faith in the Fed Reserve. The Fed tried to support economic growth and re-establish its credibility through quantitative easing. However, the effects of financial crisis in 2007 can still be felt. Unemployment rate is close to its natural level of unemployment, but this is due to people having been dropping out of the labour market since the financial crisis. In addition, actual inflation rate is also moving closer to its target.
- The Fed targets full employment and inflation rate as the indicators to change the interest rate target. Economic growth is still disappointing and inflation hasn’t reached its target. The possibility of raising interest rate target by the end of this year is lower. Another thing that the Fed considers before raising its target is that US dollar would increase. Lots of countries borrow money in US dollars. If the US dollar increases to a high level, then it would be even harder for these countries to repay its debts.
Looking at Canada
- The Bank of Canada just renewed its inflation target. The decision to maintain the 2% inflation is based on the stability of unemployment rate and interest rate target.
- Since the oil price drops 2 years ago, Canadian’s economy has not recovered to full employment rate. It’s a challenge for the BoC since the inflation rate target is close to zero percent. The credibility of the BoC to promote economic growth is being questioned. The BoC responded by demanding more fiscal expansionary policies from the government, which helps the country’s economic expansion.
Conclusion
The credibility of a central bank depends on the successfulness of achieving its own target. The more credible a central bank is, the more likely that market expectations align with the central bank’s target. To put it another way, a central bank is credible if people believe it will do what it says. The Central bank’s credibility is measured by managing the inflationary expectations, which comforts the market from unpredictable future.
