What If Monetary Policymakers Lack Credibility?

For instance, Volcker backed off on his first attempt to reduce inflation in late 1980, and then in late 1981 adopted a “whatever it takes” approach that was ultimately successful. Note, however, that it didn’t take all that long to convince people that the Fed was serious, and NGDP growth rates plunged sharply in late 1981 and 1982. And when it comes to stimulus, the central bank’s job is actually much easier in a political sense. Volcker faced doubts because a contractionary monetary policy hurts workers, businesses and borrowers. There was intense pressure on him to back off on the tight money policy. In contrast, a policy aimed at raising inflation from zero to 2% tends to make the economy better in the short run, and thus is less politically controversial.

Central banks are not completely transparent, but they are also not particularly secretive. Top Fed officials frequently describe their policy preferences to people in the media. Thus I doubt that a sincere and publicly announced policy to do whatever it takes to hit an NGDP level target (or price level target) would be non-credible. On the other hand, I could easily imagine such a policy not being sincere.

Consider the following example. Suppose that in 2003, BOJ policymakers announced that they were going to adopt Lars Svensson’s “foolproof” plan to escape from a liquidity trap. They say that they will do “whatever it takes” to hit the target amount of yen depreciation. But privately, BOJ officials decide that if the US complains too strongly about a weak yen, and threatens trade sanctions, they will back off. That’s not a sincere “whatever it takes” policy decision, and the markets would (correctly) find the promise non-credible. They’d see right through it.

Image Source: Pexels

In the vast majority of cases, promises are seen as non-credible because they are not in fact sincere, and when sincere they are seen as credible. For that reason, I’m not very worried about the hypothetical raised by Trevor. Nonetheless, let’s consider the outcome of a sincere promise that was seen as being non-credible, no matter how remote that possibility. Suppose the BOJ made the sincere decision to implement Svensson’s recommendation regardless of how much flack they received from the US, but the decision was not credible. What then?

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