What If Monetary Policymakers Lack Credibility?

I’d still say the policy was a scalpel, not a machete. Yes, the BOJ would probably have to increase the monetary base dramatically, as speculators would anticipate big profits if and when the BOJ caved in and let the yen appreciate. But in the longer term, the central bank that abandons its stimulus is actually forced to do more money creation than the sincere central bank.

Thus in early 2015, both the Swiss and Danish central banks were under pressure from speculators who anticipated a break in their currency’s euro exchange rate peg. The Swiss did cave in, a decision that in retrospect was clearly a mistake, whereas the Danish central bank refused to give in to speculators. Indeed I’d even go further. I suspect that speculators attacked the Swiss franc in early 2015 partly because they anticipated that the SNB was not sincere, and would soon let the franc appreciate as a result of the false belief that Switzerland was threatened with spillover inflation from the eurozone. Speculators didn’t so much force the SNB’s hand as they anticipated a bad decision that was already in the works.

Denmark got the last laugh, however, as once speculators saw the Danes would not let the krone appreciate, they stopped speculating in their currency. Thus, in the long run, the SNB had to increase their monetary base far more than the Danish central bank, as speculators assumed that the Swiss franc would continue to appreciate over time.

Given the fact that a non-credible central bank might have to dramatically boost the monetary base, why do I insist that this policy is a scalpel and not a machete? Because in this case it is more useful to think of the policy instrument as the exchange rate, not the base. The monetary base might change dramatically, but only in service of a central bank policy aimed at targeting the exchange rate (the scalpel) at a precise level.

Here’s an analogy. Consider a Taylor Rule-type policy in 1991, which sets the fed funds rate at 3%. Then assume a sudden collapse of the Soviet bloc, which leads to massive hoarding of US currency. To keep the fed funds rate at 3%, the Fed must accommodate that demand by printing enough base money to meet the growing demand for US currency in the former Soviet Union. From the perspective of the rapidly growing monetary base, policy looks like a blunt instrument, a machete. But from the perspective of the fed funds target, policy looks like a scalpel, a very precise instrument that keeps the fed funds rate exactly where the Fed wants it.

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