Defining central bank credibility

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.

Leave a comment


  1. Very interesting post indeed! I just have a brief comment: the ECB has not targeted M3. From 1999 to 2003, it announced a reference (but not a target) value for M3 growth compatible with medium/long term price stability. This is why many economists (me among them) made a critique on the lack of a proper and well-defined rule that made the ECB predictable (and thus transparent and credible). After 2003 the ECB stopped announcing that reference value and thus the monetary rule has watered down even more (and hence, its transparency). In essence, the ECB did not follow the Bundesbank’s traditional monetary targeting strategy, nor the inflation targeting startegy of the BoEngland.
    I agree that the Federal Reserve is the most discretional of all the leading central banks.

    Congratulations for the blog, that I follow with interest!

    Juan Castañeda

  2. Benjamin Cole

     /  December 14, 2011

    Excellent post. Yeah–and also, you can’t eat credibility.

  3. Alex Salter

     /  December 14, 2011

    Yup. A credible group of central bankers can make an announcement and watch the market do the work for them.

  4. David Pearson

     /  December 15, 2011

    Credibility depends in part on having a reliable mechanism for supplying money. As you say, in the presence of such a mechanism, not much money need be supplied: velocity can do the work.

    However, I disagree with the mechanism you imply in your previous post. QE does not supply “money”; it supplies reserves which are either demanded by banks or “Excess”. Excess reserves are a short term asset of the banking system, and not a means of payment. Thus, under the initial condition where banks do not demand reserves, a central bank has no credible means of supplying money. Sure, it can threaten to supply lots of money in the future, when banks start to demand additional reserves, but it has no way of convincing actors that that future will arrive.

    The above is a bit overstated. I do think a central bank can create demand for additional reserves when none exists. It can do so by appearing to act irresponsibly with respect to future inflation. One way to do this is to signal by making very strong commitments such as, “we don’t care if long term inflation rises to 5%, we will not act to contain it.” Unfortunately, such statements are not conducive to the long term goal of 2% inflation. There is a trade-off between velocity and price stability, and MM’s seem reluctant to acknowledge this cost.


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