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Mixed Messages Threaten Fed’s Credibility

Economics Finance

On Friday Federal Reserve Chair Janet Yellen presented the opening remarks for the Kansas City Fed’s prestigious annual conference in Jackson Hole, Wyoming.  She took the opportunity to outline what she sees as a strengthening argument in favor of tightening monetary policy. As John Taylor notes, this conference has evolved from a relatively modest affair attended by only a few Fed policymakers and a total of four journalists in 1982 into an event that hosts officials from many foreign central banks and scores of reporters from around the world. 

By coincidence, on the same morning as Chair Yellen’s speech, the US Commerce Department announced that real GDP grew during the second quarter at a revised rate of 1.1 percent.  Meanwhile, the Fed’s preferred measure of inflation, based on the price index for personal consumption expenditures less food and energy, has run consistently below its two-percent target since early 2012.  The apparent disconnect between slow real growth with below-target inflation and Chair Yellen’s comments on the likelihood of a monetary tightening raises an important question about the Fed and its policies: Are they “credible?”  Many critics argue that they are not.  To restore its lost credibility, the Fed needs to deliver to the public a more consistent and coherent message about its policy objectives.

Credibility was an important topic of academic research in the 1980s; this is not surprising when it is recalled that central banks in most developed countries made repeated promises to contain inflation during the 1970s and subsequently demonstrated their inability or unwillingness to achieve this result.  In this research of three decades ago, academics generally argued that credibility could be gained if a central bank made a commitment to achieving a low and stable rate of inflation, adopted a rule to guide the implementation of its monetary policy actions, and tied the performance of its leading policymakers to a contract or other incentive mechanism.

After serving as Vice Chair of the Federal Reserve System during the middle 1990s, Princeton economics professor Alan Blinder investigated whether ideas about credibility expressed in the academic research were shared by the central bankers who implemented monetary policy in practice.  In general, Blinder wanted to know whether these two groups held similar views on two broad questions: Why is credibility important to the success of monetary policy and what factors are most important in achieving credibility?

To find out, Professor Blinder sent questionnaires to the heads of 127 central banks and a similar number of academic economists who specialize on monetary policy.  With regard to the first question – why credibility is important – both groups cited lower costs of reducing inflation and greater ease of keeping inflation stable once a low rate had been reached.  Perhaps surprisingly, on the second question – how credibility might be achieved – neither group thought that the adoption of a monetary policy rule was an effective means to this end.  And both groups also agreed that performance contracts for central bankers would not be an effective way to gain credibility.

If not by rules or contracts, how might a central bank become credible?  As Blinder describes the result:

"When it comes to appraising methods of building or creating credibility, the views of central bankers and economists are closely aligned.  Establishing a history of living up to its word is ranked first ….

"In brief, there appear to be no shortcuts to greater credibility.  Respondents think central banks get their credibility the old-fashioned way: They earn it by building a track record for honesty and inflation-aversion (in that order of importance), not by limiting their discretion via commitment technologies or entering into incentive-compatible contracts."

Which brings us full circle to Chair Yellen’s comments last week: To what degree can the Federal Reserve and its policies be viewed as “credible” when inflation persists at rates below the announced target of two percent, real output growth still runs below the economy’s potential, and Fed officials indicate that these conditions call for contractionary actions?

Policymakers could better explain themselves by appealing to the well-known lags between monetary actions and their effects, arguing that modest and gradual interest rate increases now are needed to prevent inflation from overshooting its target in the future.  Yet, in a meeting with activists just before the Jackson Hole conference, several Fed officials appeared to say, instead, that they plan to let the economy “run hot,” presumably accepting inflation rates above target, in order to promote faster real growth and lower unemployment.  The critics are right: mixed messages like these really do threaten the Federal Reserve’s credibility.  Whatever their ultimate objectives might be, Fed officials need to be clearer, and more consistent, in their public statements about them.

Michael Belongia is a professor of economics at the University of Mississippi. Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee

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