Federal Reserve Credibility and Reputation in Historical Perspective

Introduction

The Federal Reserve and many other central banks have achieved remarkable credibility in the two decades preceding the financial crisis of 2007-2008. Central bank credibility has gone through a pendulum in the past century and a half. It was high under the gold standard before World War I and in the 1920s, declined dramatically in the middle of the twentieth century and then was restored in the 1980s. The recent good performance in many countries was enhanced by the adoption of inflation targeting. The recent financial crisis and the call for central bankers to focus more on financial stability and especially the tools of macro prudential regulation may pose significant challenges for central banks to preserve their credibility in the future.

I define central bank credibility as a commitment to follow well-articulated and transparent rules and policy goals. Credibility is directly tied to performance “Credibility depends on the history of policy making and the behavior of the policy institution” (Brunner 1983). Following my work with Pierre Siklos (Bordo and Siklos 2014) I interpret credibility in terms of inflation performance. Credibility is a flow variable that changes as observed inflation is seen to deviate from a time-varying objective. Credibility also affects a central bank’s reputation, which can be viewed as a stock variable. “It takes many good deeds to build a good reputation, and only one bad one to lose it” (Benjamin Franklin).

Credibility builds trust in institutions and helps weather crises. It helps markets and the public discern the actual policies being followed. The key determinants of credibility are the monetary regime in place and institutional factors such as the mandate of the central bank, its autonomy with respect of the government and the governance of the institution.

Bordo and Siklos (2014) argue that a central bank is deemed credible when it delivers, subject to a random error, the implied inflation rate objective conditional on the monetary regime in place. We derive the inflation objective using a Taylor Rule and we adjust it for the type of policy instrument used in different monetary regimes: the interest rate, a monetary aggregate and the exchange rate.

The history of central bank credibility is tied up with the history of policy regimes.

In Bordo and Siklos (2014) we compare credibility in three broadly defined regimes: a) the gold standard which includes the pre 1914 classical gold standard and the 1920s gold exchange standard; b) the Bretton Woods era which includes the years when the U.S. indirectly adhered to the pegged price of gold nominal anchor and the period after when the golden anchor was raised leading to the Great Inflation; c) the recent fiat money regime with the primacy of low inflation. As a measure of the evolution of credibility across regimes Figure 1 shows the pattern of expected and observed inflation for 10 countries for each regime. As can be seen the figure reveals a pendulum pattern. Credibility was high in the gold standard era, considerably less so in the Bretton Woods era and then back to the pattern of the gold standard under the current regime with primacy for low inflation.

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