What can happen when economic policy-makers lose credibility?

Fears that central banks’ commitment to low inflation is weakening or that a government’s fiscal plans are uncosted, unchecked and unfunded can be highly damaging for households, businesses and the public authorities themselves. A lack of credibility is a disaster for policy-makers.

If your work, performance or decisions are described as incredible, most people take it as a compliment. But as well as this favourable interpretation, there is a more pejorative implication, one that can be particularly dangerous for economic policy-makers: that your work, performance or decisions are not credible.

A lack of credibility is a disaster for policy-makers. Credibility is so important because most economic decisions, such as household spending or firm investments, involve making plans about the future. This also applies to decisions about price setting, such as wages demanded and paid, and prices charged by firms.

Macroeconomic policy can help with this planning if it promotes a stable economic and financial environment and convinces people that the economy will evolve in predictable ways. In that sense, macroeconomic policy is concerned with managing the expectations of different groups of people or organisations in the economy.

Fiscal credibility

When a government like the UK’s is making decisions about fiscal policy – measures related to public spending and taxation – it can finance itself more easily and more cheaply when it is credible. This is because the UK, like most countries, maintains a large stock of government debt and regularly runs deficits by spending more than it collects in tax revenue.

There is nothing wrong or unusual about this. But it does mean that the government needs to borrow money regularly. And like any borrower, prospective lenders want to be sure that they will get repaid.

Governments are not like households or firms – there is a greater expectation that the country will still be around to pay back any borrowing. They also have the power to tax to be able to make their repayments.

But governments do sometimes default on their debts and the greater the chance of this happening, the less enthusiastically lenders will make funds available. Of course, they can offer to pay back higher interest rates, and this will make it worthwhile for lenders to take the risk.

But higher interest rates mean that a greater share of government spending goes on interest payments rather than providing useful public goods and services, or reducing taxes.

The role of credibility has been particularly important in macroeconomics for around 50 years. And a key part of maintaining credibility is how institutions are set up.

For example, these days, the central bank – the Bank of England in the case of the UK – is typically independent from politicians. This allows it to make tough decisions, even at uncomfortable times, to ensure it gets as close as possible to achieving its objectives of low and stable inflation (and financial stability).

More recently, governments have subjected their fiscal plans to scrutiny by independent experts – the Office for Budget Responsibility (OBR) in the UK – while still, rightly, leaving the specific policy choices to elected officials.

This is why budgets can be costly if they are not set against a clear and credible plan to finance any new spending (or tax cuts). Even if that financing will take place over many years or even decades, the presence of a clear plan can reassure potential lenders that the policies are well thought out and sound. Transparency of plans and endorsement by an independent fiscal council provide reassurance to the markets and the public.

This is part of what made the UK’s recent ‘mini budget’ such a disaster. By declaring it as a 'non-budget', the new Chancellor rendered it outside the remit of the OBR, which would usually provide independent macroeconomic forecasts for any budget, as well as properly costing proposed policies. Immediately, lenders became suspicious and nervous.

Combined with other events, such as the recent removal from office of the most senior Treasury civil servant and repeated talk that the government was thinking about reviewing the mandate of the Bank of England, alarm bells started to ring. Loans to the UK government, because they now appeared riskier, would need to pay a higher interest rate.

Monetary policy credibility

It is not just governments that need to be concerned about credibility. Central banks equally must worry about their reputation. Academic economists don’t necessarily always agree with one other; and neither do academics and policy-makers on all issues. But one thing on which there is reasonably strong agreement is the need for monetary policy to be credible.

Central banks can more easily hit their inflation target if everyone believes that inflation will turn out to be at the target level. This is because when they make financial and economic decisions, they do so with the expectation that prices will increase by something close to the target.

So, when firms decide how much to charge for their goods or services, when workers determine what wage to ask for, or when banks choose what interest rate to charge on a loan, they base it on expecting the target rate. In doing so, they then contribute to everyone facing prices consistent with the target. It is self-reinforcing.

Alan Blinder, an American economist and former central banker at the US Federal Reserve, once wrote that ‘A central bank is credible if people believe it will do what it says’ (Blinder, 2000). But credibility is not a given: it is earned.

Indeed, the Federal Reserve’s policy-making body (called the Federal Open Market Committee, FOMC) – arguably the most powerful and credible central bank in the world – worries consistently about its inflation-fighting credentials (Cieslak et al, 2022).

Of course, there are times when it makes sense to throw caution to the wind – this is the use of credibility to provide insurance against the worst possible outcomes. But there are other moments when the potential loss of anchored inflation expectations must be taken seriously. Sometimes, the risks of the latter follow from a period when the central bank provided the insurance and prevented a potentially much-worse downturn.

The case for higher interest rates

In recent months, some commentators have argued that the Bank of England raising interest rates is counterproductive. Why, the argument goes, should the central bank raise interest rates and compound the misery of high inflation for people by increasing their mortgage repayments and the costs of debt repayment for firms? There are two answers.

The first concerns the exchange rate. When central banks raise rates, this tends to strengthen the exchange rate. A stronger (more appreciated) exchange rate means that goods priced in foreign currency become relatively cheaper: for example, oil and gas, paid for in dollars, become cheaper in terms of sterling. The opposite happens when rates are lowered.

Importantly, it is the relative movement of interest rates versus other central banks that can cause this. Even if the Bank of England raises interest rates by 50 basis points (bps or hundredths of 1%), this can seem too little when other central banks are raising by 75 bps, as the Fed has done several times recently. The ensuing depreciation of sterling introduces even greater inflationary pressure into the economy.

The second answer is credibility. This is not always intuitive. It relies on realising that the official central bank policy interest rates are only one driver of the rates that households, firms and the government itself are facing.

Like any investor, a lender worries about the return – the annual income they will receive from the borrower for use of the loaned amount. While most lending contracts are expressed in money terms (the nominal value), what really matters is the return after adjusting for inflation (the real value) because this determines the purchasing power of the return.

Lenders wanting to receive a 2% real return will have to add the inflation that they expect over the life of the loan. Lenders also worry that the future may turn out differently to how they expect. When they worry that inflation might be more volatile in the future, they increase the required return to compensate for this, in the same way that they increase the required interest rate when a borrower looks less likely to be able to repay in the future.

The central bank has two linked influences on these beliefs. The first is their framework, which, in the UK, sets the objective of the Monetary Policy Committee (MPC): to achieve a specific low and stable value of inflation (the inflation target).

The second is that the central bank takes policy actions that influence, not directly set, the real return that lenders require and hence the rates at which lenders in the economy provide loans. And the lenders must think of the amount that they will need to get over the life of the loan. This can, in the case of mortgages, be 25 years or more. Lenders need to think about what actions the central bank will take in the future.

The central bank must take policy actions to ensure that it maximises the chances that it will hit the inflation target. Sometimes these decisions are difficult ones. A former long-serving Chair of the Federal Reserve, William Martin Chesney Junior, described the central bank as ‘the chaperone who has ordered the punch bowl removed just when the party was really warming up’.

In some circumstances, such as those we face today, it is much tougher than that. It feels like central banks are taking away the water and paracetamol when everyone has a hangover. And the hangover wasn’t even because of their own over-indulgence – it feels like their water was spiked with vodka!

In a world where lenders understand that the central bank’s actions will ensure that inflation will be around target in the future, and not too volatile, the lending rate rises just because of the central bank’s action. This is where the central bank has maintained its credibility.

If, on the other hand, the central bank appears to ignore its inflation target and instead to cut rates to try to ease the burden on households, then its credibility is likely to be lost. In this case, lenders might not expect policy rates to go up, but lending rates rise anyway because the weakened commitment to the inflation target means that the lenders charge more for expected higher and more volatile inflation.

In both cases, interest rates faced by households and businesses rise. So, is there a difference between these two scenarios?

In the short run, maybe not – both are painful for households and businesses. But in a world where credibility is maintained, the central bank will at least have retained anchored inflation expectations. This gives it some chance of bringing mortgage rates down when inflation is reduced.

In the world where credibility is lost, the central bank will have to work harder, with higher interest rates for longer, to show that it really is committed to low and stable inflation again.

Central banks want to take decisions that do the least amount of damage. Building up credibility is hard, so working not to lose it can be the best option. This can even be the case if it involves short-run pain (for a discussion of the US experience in the 1970s and 1980s, see Reis, 2021).

But since tough monetary policy risks adverse effects on the economy and the financial sector, the central bank needs to strike a balance between toughness, but not counterproductive destruction. This is why it is much easier to not lose hard-earned credibility.

In those difficult circumstances, fiscal policy – changing taxation or public spending – can be used to safeguard the most vulnerable. What is not helpful is talk of weakening the commitment to low inflation (because interest rates rise).

Similarly, uncosted and unchecked fiscal plans – which cause markets to worry that the government will inflate away the debt (because interest rates rise) – can be damaging.

Further, any policies that raise interest rates increase the risks to financial stability, which make the Bank of England’s job of re-anchoring inflation expectations much harder. The monetary-fiscal mix, even in a world of independent institutions, remains important for macroeconomic outcomes.