In a comment to my previous post on QE and NGDP targeting Joseph Ward argues that the Federal Reserve has “relatively solid central bank credibility”. The question is of course how to define central bank credibility.

To me a central bank is credible if the markets (and the general public) expect the central bank to hit the targets it have. The problem of course for the Fed is that it does not have a target. That makes it pretty hard to say whether it is credible or not.

Another way of saying whether a central bank is credible or not is to look at the predictability of nominal variables: money suppy, velocity, nominal wages, prices, inflation, NGDP, the exchange rates etc. I am pretty sure that if you estimate of example simple AR-models for these variables you will see the error-term in the models has exploded since 2008. I must, however, say I am guessing here. but I am pretty sure I am right – maybe an econometrician out there would try to estimate it?

In the case of the ECB the collapse in credibility is pretty clear. The ECB used to have a two-pillar policy – targeting directly or indirectly M3 growth and inflation. Judging from market expectations for medium term inflation the credibility is not good – in fact it has never been this bad. Medium-term inflation expectations are well-below the 2% inflation target. In terms of M3 the ECB has normally targeted a reference rate around 4.5% y/y. The actual growth rate on M3 is much below this “target”.

HOWEVER, if the central banks were indeed so credible then the markets should fully believe any nominal target they would announce. So if the Fed is 100% credible and announce that it will increase NGDP by 15% over the coming two years then there should be no problem meeting this target – without printing more money. What would happen is the money-velocity would jump, which with an unchanged money supply would increase NGDP.

During the Great Moderation there was a very high degree of negative correlation between M and V growth in the US. This indicates in my view that markets expected the Fed to meet a NGDP “target” and in that sense monetary policy became endogenous – pretty much in the same way as in a Selgin-White Free Banking model.