Monetary policy - United States ; Monetary policy - Japan ; Bank of Japan

John P. Judd

Michael Hutchison

English

Research Papers in Economics

FRBSF
july 14, 1989 WEEKLY LETTER
What Makes a Central Bank Credible?
Economists have noted that there is a tradeoff in
the short run between inflation and employment,
inthesense that a central bank's pursuit of dis-
inflationary policy frequently entails a temporary
decline in employment and output. However, the
magnitude of this tradeoff varies from country to
country. For example, following the second oil-
price shock in 1979, japan's central bank, the
Bank of japan (Boj), restored price stability
quickly without engendering a recession, while
in the United States, the Federal Reserve was able
to bring inflation under control only after several
years and two back-to-back recessions.
What accounts for this difference in the way the
japanese and American economies responded to
disinflationary monetary policies? Economists
suggest that it has a lot to do with central bank
credibility. Credibility means that the public
quickly adjusts its expectations concerning future
policy in response to the announcement of a
change in policy, or to policy actions that suggest
a new policy stance. Thus, a central bank with
"credibility" can announce a new disinflationary
monetary policy and quicklyachieve a lower
inflation rate without a prolonged economic
downturn because the public expects it to follow
through with its new policy long enough to be
successful. Consequently, wage and price in-
creases moderate quickly.
In contrast, when a central bank with little or no
credibility pursues a disinflationary policy, the
public is much more skeptical about the central
bank's determination to fight inflation. As a re-
sult, inflationary expectations decline only
gradually.
In practice, it is not clear how a central bank
makes its policies credible. Some observers
argue that the procedures followed by the central
bank in formulating and implementing monetary
policy play an important role. Others argue that
establishing a systematic record of successful
action against inflation is .more effective. This
Letter evaluates these arguments in light of the
BoJ's experience, and concludes with some
observations on Federal Reserve credibility.
j
Central bank behavior
In general, the impact of a change in monetary
policy is not felt immediately. In the United
States, for example, it takes about six months for
a change in policy to affect the pace of eco-
nomic activity, while the lag from policy actions
to inflation is about 18 to 24 months. Such lags
make it difficult for the public to determine when
a changein monetary policy has occurred and
whether the new policy is being pursued suc-
cessfully. The central bank's credibility, or lack
thereof, will determine the ;;peed with which the
public adjusts inflation eKpectations in response
to a new policy stance and ultimately, the extent
to which employment and output will be af-
fected by a change in policy.
Economic theory can provide insights into the
way central banks make their policies credible.
Economists Allan Meltzer and Alex Cukierman
have developed a model that defines credibility
as the speed with which the public recognizes
that a change in policy has occurred based upon
observed policy actions. The faster these expec-
tations adjust, the higher is credibility, and the
lower are the costs of disinflation. Conversely,
slow adjustmentimplies low credibility and
means that disinflation will be more costly.
When expectations are formed "rationally;' this
speed of adjustment, and hence credibility, is
determined by: 1) the frequency with which the
central bank's objectives have changed in the
past, 2) the extent to which the central bank has
displayed a preference for long-run inflation
control over short-run output gains, and 3) the
precision with which the central bank controls
its target variable (assumed in this model to be
the money supply).
The first factor, the stability of the central
bank's objectives, is important in determining
how much significance the public will attach to
an apparent change in policy actions. A central
bank's objectives may change over time for many
reasons, including, for example, a change in the
composition of the central bank's decision-
making body, or an unexpected developmentFRBSF
such as a stock-market crash. However, frequent
changes in these objectives will make the central
bank's policies less crediblesincethepublic will
not see current policy actions as good indicators
of future policy actions.
The second factor that influences credibility is
the relative importance the central bankattaches
to eachof its variousopjectives.. ln themodel
developed by Meltzer and Cukierman, central
banks prefer both low inflation and rapid output
growth. However, in the long run,centralbanks
cannot control the level of output,whichisdeter-
mined by underlying supply conditions,Thus, if
central bank policy causes output toriseabove
trend today, output must fall short of th.is trend at
some point inthe future. Prices,on the other
hand, can be permanently affected by central
bank policy.
The policies a central bank pursues depend upon
which of these two objectives it considers more
important. Thus, a central bank that considers
rapid output growth relatiyely more imPortant
will tend to seek short-run gains inthe pace of
economicactivity, even th()ugh th~segai9swill
tendto cause prices to rise in the 109grun. For
such a central bank, adisinflationary policy will
notbe particularly credible since thepublicwill
expect it to swerve from its courseto s~ek short-
run output gains.
In contrast,acentralqank that considers low
inflation more important will tend g~nerally to
forego opportunities to push output temporarily
above its full-employment level, since th.is would
mean higherinflationin the long run. It consis-
tently will implementan. anti-inflationary stance,
and its policies will be highly credible.
more apt consistently to meet those targets than
will a central bank that places greater weight on
short-run output gains.
Clearly, the former will be the more credible
of the two central banks. However, it probably
would be highly credible even if it did not
announce targets, since it would have achieved
credibility through its actions. In this case, decid-
ing to announce targets may not significantly
enhance an already high level of credibility.
Bank of Japan
The BoJ is among the world's most credible
central banks, and typically, this is cited as an
important reason for its success in taming infla-
tion without losses of output and employment.
As noted above, it avoided a recession during
the second oil shock in 1978-79-in contrast to
every other major industrial country-and, at
the same time, quickly restored price stability.
The seemingly low cost of fighting inflation in
Japan has not always been the case, however.
Following the first oil shock in 1973, the BoJ im-
mediately tightened monetary policy and raised
interest rates. The result was a substantial re-
cession, the largest and longest drop in output
growth that Japan has experienced in the postwar
period. Some have argued that an increase in BoJ
credibility is the cause of the more favorable
inflation/employment tradeoff in the period fol-
lowing this episode. But what accounts for that
enhanced credibility?
In July 1978, the BoJ began to announce pro-
jections for broad money growth on a quarterly
basis. A number of academic economists and
journalists havecited the accuracy with which
these targets have been metas one important
reason for the high credibility of the Bol How-
ever, a closer look casts doubt on the significance
of this factor as a source of credibility. First, the
projections for money growth cover four quarters
ending one quarter ahead; that is, the projec-
tions average three quarters of actual money
growth and only one quarter of projected money
growth. When transformed into true one-quarter-
ahead projections, the money projection errors
are about fourtimes larger than at first they
appear, and are roughly the same size as the
errors made by the Federal Reserve in compar-
able one-quarter-ahead projections.Again, it appears that results, not procedures,
count for central bank credibility. It is through
results that a central bank has its best chance to
demonstrate that, indeed, it places sufficient
emphasis on inflation control in its policy
decisions to be a credible inflation fighter.
not procedures, are what count for credibility.
In the early 1980s, the Fed instituted a new
reserves-oriented monetary-control procedure
designed to gain better control of the monetary
aggregates. Nonetheless, inflation fell from
double-digit rates to around four percent only
after two back-to-back recessions. If the new
control procedures had enhanced the Fed's cred-
ibility, one might expect to see a lower inflation/
employment tradeoff during this episode than
that which had prevailed in the 1970s. However,
studies, such as the one by economist Benjamin
Friedman, have concluded that the tradeoff dur-
ing the early 1980s is statistically indistinguish-
able from that in the 1970s, when Fed policy
operations focused much more on interest rates.
In recent years, the Fed's credibility has improved
considerably, largely because the Fed has been
willing to stick to an anti-inflation policy since
early in the decade. The U.s. economy has bene-
fited from this enhanced credibility. In the past
two years, monetary policy has tightened signifi-
cantly, as suggested by substantial rises in short-
term interest rates and the associated slowdown
in the growth of the monetary aggregates. Yet
this rise in short rates has had little effect on
long-term interest rates. According to surveys
conducted by Drexel Burnham Lambert, it ap-
pears that financial decision makers' longer-term
inflation expectations have declined over time,
and this has helped to keep long-term interest
rates from rising. (See this Letter, March 10,
1989.) Inflation expectations have continued to
moderate steadily as the Fed has maintained rela-
tively low rates of inflation for the past six years.
Second, the base for the new projection each
quarter is the actual level of M2 + CDs three
quarters earlier. This permits so-called full "base
drift" in the monetary range each quarter. The
Fed has been criticized heavily for permitting
base drift (although it does so only once per
year), because this approach "forgives" past
misses. Thus, the BoJ's implicit use of base drift
each quarter most likely has not contributed to
the credibility of its monetary announcements.
Third, Boj officials have noted repeatedly that
monetary announcements should not be inter-
preted as targets, but rather as projections. This
is an important distinction because it affects
how monetary policy is conducted in the face
of deviations of money from its range. The an-
nounced money range simply represents the BoJ's
best guess about the most likely path for money,
given its projections for income and prices and
its planned policy actions, which are defined in
terms of short-term interest rates. A deviation of
money from its projected range would not neces-
sarily elicit a policy response.
Thus, it is unlikely that the change in monetary
control procedures in 1978 can account for the
increase in the BoJ's credibility. Rather, that
credibility appears to have been earned through
performance. Although initially it may not have
been viewed as entirely credible, the Boj demon-
strated its resolve to fight inflation by quickly and
decisively reacting to the first oil price shock.
Money growth was lowered to 11% in 1974-less
than half its rate in the previous year-and in-
terest rates were raised by almost 10 percentage
points, the largest increase among the major
industrial countries. At the same time, the switch
in the BoJ's policy objectives toward price sta-
bility became apparent. Although the 1974-75
recession in japan was very costly in terms of lost
employment and output, by the middle of 1975,
the inflation rate was below double digits and
has continued falling since then. japan now con-
sistently ranks among the lowest inflation coun-
tries in the world. The result is that firms and
unions recognize the fundamental shift in the
BoJ's policy objectives, which have been pursued
very consistently for more than a decade.
Federal Reserve
The Federal Reserve's experience in the 1980s
also seems consistent with the view that results,
Michael Hutchison
Visiting Scholar, FRBSF
and Assistant Professor
University of California,
Santa Cruz
John P. Judd
Vice President and
Associate Director
of Research
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.Research Department
Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120
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What makes a central bank credible?

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