Monetary policy is a matter of confidence

The big central banks with their extremely loose monetary policy are coming under heavy attack. While it seemed necessary and justified at the time to take an expansionary stance to tackle the acute crisis, doubts are now growing. The long-lasting crisis policy appears to have undermined the confidence in the central banks‘ ability to control economic growth and inflation. However, confidence in monetary policy and its representatives is extremely important because where credibility is high the central banks will find it much easier to achieve their targets.

But what exactly is credibility? Initially, credibility is simply an abstract term. Credibility can be defined as the confidence of investors and the public in a central bank’s ability and willingness to achieve its intended (and stated) aims on a long-term basis. To this end, we have devised a credibility indicator, which reflects the confidence of market participants in the ability of a central bank to achieve its stated target.

The index is based mainly on the balance between a central bank’s key inflation target and the longer-term market-based inflation expectations. Ideally, this yields a value of 1.

However, the central banks are currently a long way off this ideal scenario. The barometer shows that the difference between the market’s longer-term inflation expectations and the inflation targets of the European Central Bank (ECB) and the US Federal Reserve (Fed) was very high recently. From 2008 to 2010 as well as from mid-2015 to the end of 2016, the indicator for the ECB was at times significantly below the level we see as being compatible with a high level of credibility. We have set this level at 0.8 index points. The indicator in the US has also been below this level of high credibility since the start of 2015. This is reflected in market participants’ diminishing confidence in the effectiveness of the monetary policy pursued by both the ECB and the Fed. The index only recently picked up again with the rise in inflation expectations after the US election.

Even so, the two central banks have enjoyed better success over a lengthy period in achieving their targets in the past than was inferred by the frequently-voiced subjective perceptions. We can see from the last ten years that the credibility indicators are at a very high level on the whole. All in all, the central banks can be regarded as having a high degree of credibility – but with increasing phases of weakness.

In other words: it is not the current level of credibility that poses a threat but rather the downward-pointing trend. It is therefore necessary for the central banks to improve communications against the backdrop of a weakening reputation. The Fed has recently been irritated by individual economic data instead of prudently following its general approach. This was perceived by the public more as uncertainty – and less as appropriate fine-tuning. At the same time, the constant adjustments to the ECB’s catalogue of measures were perceived as impotence on the part of the central bank to accelerate economic growth and steer inflation towards its target. In both cases, the central banks should have adopted a calm communications strategy that emphasised continuity so as to produce the desired effect of effortless control.

The challenge now facing the central banks is to slowly exit the expansionary monetary policy without creating a credibility shock. They will have to calmly present the normalization of monetary policy and act as one when implementing the measures announced in a reliable manner. Saying what you do and doing what you say is a guarantee for credibility.

Of course all of these efforts are pointless if political interference is rife and becomes too apparent. This scenario would no doubt quickly erode a central banks‘ credibility, and prevent it from implementing an efficient monetary policy and controlling the financial markets.

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