It is worth noting there are also times when policymakers go out of their way to shock investors. For example, when the Bank of Japan (BOJ) cut into negative territory in January 2016, this came as a shock to investors because the central bank had delivered guidance suggesting negative rates were very unlikely.
In this case, the policy shock was a feature, not a bug of the policy. The shock was to try to communicate a regime shift to investors. It was intended to show that the BOJ would do whatever was required to fight deflation. It deliberately sacrificed its promise credibility about not going negative in order to pursue a larger goal – achieving its mandated inflation target.
This brings us nicely to mandate credibility. This is the form of credibility that academics tend to have in mind when they talk about credibility. Its importance stems from the insight that policymakers often face a time-inconsistency problem.
For example, policymakers may wish to lower inflation and inflation expectations, so they announce a policy to do so that involves temporarily increasing unemployment. This plan then causes investors and other decision makers to lower their inflation forecasts. But now inflation expectations have fallen, which means policymakers will likely want to renege on the promised plan that causes unemployment. Rational decision makers, realizing that policymakers face inconsistent preferences through time, never believe the original promise to lower inflation.
Only credible policymakers, those decision makers who will do the right thing to meet their mandate no matter how painful, will be believed. We believe a central bank cannot do its job without mandate credibility.
We believe a central bank cannot do its job without mandate credibility.
When faced with a conflict between promise credibility and mandate credibility, the central bank should always choose mandate credibility. Promise credibility is nice to have but is only ever instrumentally valuable in so far as it helps to achieve mandate goals.
At times, central banks have not always behaved this way. For example the U.S. Federal Reserve’s decision to hike interest rates in December 2015 looked at times more like an attempt to stand by their earlier 2015 guidance that rates would be hiked sometime that year, rather than the result of a mandate-driven cost benefit analysis. But the mandate should be the only thing that ultimately matters.
The downward revision of the Fed’s dots and recent speeches from Yellen stressing a cautious approach in response to falling inflation expectations, can be interpreted as the Fed backing away from its promise credibility of delivering four hikes this year in the service of achieving its mandate goal of higher inflation.
This puts us in a position to better judge the claims that particular central banks may be undermining their credibility. To the extent that this represents a complaint that the central bank has failed to live up to some form of guidance – has undermined promise credibility – we should be more relaxed.