Some investors might relate to this Shakespeare quote from Henry VIII: “His promises were, as he then was, might; But his performance, as he is now, nothing.” Investors may feel that it aptly describes the way some central banks have behaved recently.
But when investors disapprove of certain central bank decisions, you will often hear them talk of “undermining [the central bank’s] credibility.”
Credibility; however, is a very slippery term. You will regularly hear it used in quite different ways, often within the same breath.
It is therefore useful to distinguish between two senses of the term:
• Promise credibility – that the central bank will follow a particular path of policy due to some perceived promise that it will do so.
• Mandate credibility – that the central bank will ultimately do what it takes to achieve its mandates over the long run.
As central banks have significantly increased their communication since the financial crisis of 2008, issues around promise credibility have become more pronounced.
More disclosure from central banks about their policy plans means investors will tend to shape their expectations around these plans. There are good reasons why this should deliver better policy outcomes. Generally, policymakers look to avoid shocking markets and creating unnecessary volatility, and they like to allow people to make plans based on reasonable expectations about the future.
This is part of the reason the Federal Reserve (Fed) releases its dot plot showing where policymakers expect interest rates to be over time. This should help decision makers form reasonable expectations about the future, making policy setting easier as markets do the job for you, so to say.
The problem comes when policymakers fail to deliver on the policy plans they have disclosed. This is particularly true when the plans are incorrectly perceived as promises. Bank of England Governor Mark Carney was accused by a Member of Parliament of being an unreliable boyfriend because he was seen as breaking previous promises about how monetary policy would evolve. Providing too much guidance to investors, or failing to live up to this guidance, can hurt central banks’ ability to influence expectations as investors adopt a “once bitten, twice shy” mantra.