Central Bank Credibility Research Articles

Effects of oil shocks and central bank credibility on price diffusion

This paper investigates the effects of international oil price pass-through and the central bank credibility on the diffusion of price increases among consumer prices. We use data that permit us to consider the international oil price pass-through and calculate the price diffusion index and central bank credibility indexes for nineteen countries from 2002 to 2019. The findings show that both the international oil price pass-through and the central bank credibility are relevant in explaining the price diffusion. The dynamic effects of oil price pass-through and credibility on price diffusion are long-lasting. Moreover, our results point out an asymmetry in the effect of increases and decreases in the oil price.

Central bank credibility and its effect on stabilization

This paper analyzes central bank credibility and its stabilizing effects for a set of emerging economies (EEs) and advanced economies (AEs). First, we analyze historical performance and the impact of inflation targeting on performance for nineteen countries and test whether this performance shows an interest rate stabilizing effect. To do this, we compute backward-looking credibility indicators whereby the performance metric is better when observed inflation is closer to the central bank’s explicit or implicit inflation target range. Second, we analyze whether inflation expectations have been anchored using a forward-looking asymmetric credibility indicator and whether this has a stabilization effect on reducing interest rate volatility and macroeconomic volatility in nine economies. The results show that inflation targeting improves performance significantly in nineteen countries. The findings support the hypothesis that credibility has an interest rate stabilization effect for EEs and AEs. Also, we found significant concurrent macroeconomic stabilization effects. The panel regression results show that forward-looking asymmetric credibility has a significant and negative impact on interest rate volatility, inflation volatility, output volatility, and macroeconomic volatility in both EEs and AEs. The results are robust to two different volatility measures. The findings have important policy implications: greater central bank credibility yields stabilizing effects.

Foreign participation in local currency government bond markets in emerging Asia: Benefits and pitfalls to market stability

With the objective of reducing the problem of currency mismatch, emerging Asian economies have made a concerted effort to develop the local currency government bond (LCGB) markets since the early 2000s. Since then, foreign investors have had a substantial and growing presence in the markets. This paper examines the effects of foreign participation in the LCGB markets on the yield spread. We show that the effect of high foreign participation on market stability is non-monotonic: During tranquil periods, high foreign participation helps reduce yield spread; however, in times of market distress, high foreign participation asymmetrically exacerbates the widening of the yield spread by a larger magnitude. This effect could be due to foreign investors' concerns about currency risk. This is supported by the estimation that yield spread widening during market distress is mainly driven by the currency risk component, but not the credit risk component. Our results underscore the importance of broadening the domestic investor base in the region, and maintaining a manageable exchange rate expectation and central bank credibility.

MONETARY POLICY SHOCK ON INFLATION, OUTPUT, AND EXCHANGE RATE

This study aims to estimate the impact of monetary policy shocks on inflation, output, and exchange rates during the inflation-targeting period. The data analyzed are quarterly data covering the period 2005Q3 - 2020Q1. The analysis tool used is the Vector Error Correction model with the cointegration relationships between variables. The results show that there are variations in the impact of the monetary policy shock on the response of the variables in the model. Monetary policy shocks can explain the forecast error variance of policy interest rates, inflation, exchange rates, and output, respectively, with the largest to the smallest contribution. The characteristics of shocks are unexpected and unpredictable, resulting in variability and volatility of the variable responses. Therefore, reducing the impact of the monetary policy shock can improve the effectiveness of the monetary policy. Improving the effectiveness of monetary policy can be done with the support of the central bank's credibility.

Central bank credibility and inflation expectations: a microfounded forecasting approach

AbstractCredibility is elusive, but Blinder [(2000) American Economic Review 90, 1421–1431.] generated a consensus in the literature by arguing that “A central bank is credible if people believe it will do what it says.” To implement this idea, we first measure people’s beliefs by using survey data on inflation’s expectations. Second, we compare beliefs with explicit (or tacit) targets, taking into account the uncertainty in our estimate of beliefs (asymptotic 95% robust confidence intervals). Whenever the target falls into this interval we consider the central bank credible. We consider it not credible otherwise. We apply our approach to study the credibility of the Brazilian Central Bank (BCB) by using a world-class database—the Focus Survey of forecasts. Using monthly data from January 2007 until April 2017, we estimate people’s beliefs of inflation 12 months ahead, coupled with a robust estimate of its asymptotic 95% confidence interval. Results show that the BCB was credible 65% of the time, with the exception of a few months in the beginning of 2007 and during the interval between mid-2013 throughout mid-2016.

EXPECTATIONS, STAGNATION, AND FISCAL POLICY: A NONLINEAR ANALYSIS

AbstractStagnation and fiscal policy are examined in a nonlinear stochastic New‐Keynesian model with adaptive learning. There are three steady states. The steady state targeted by policy is locally but not globally stable under learning. A severe pessimistic expectations shock can trap the economy in a stagnation regime, underpinned by a low‐level steady state, with falling inflation and output. A large fiscal stimulus may be needed to avoid or emerge from stagnation, and the impacts of forward guidance, credit frictions, central bank credibility, and policy delay are studied. Our model encompasses a wide range of outcomes arising from pessimistic expectations shocks.

Sovereign Debt Sustainability and Central Bank Credibility

This article surveys the literature on sovereign debt sustainability from its origins in the mid-1980s to the present and focuses on four debates. First, we evaluate the shift from an accounting-based view of debt sustainability using government borrowing rates to a model-based view that uses stochastic discount rates. Second, we review empirical tests, focusing on the relationship between primary balances and debt. Third, we discuss debt sustainability in the presence of rollover risk. And fourth, we evaluate whether government borrowing costs below rates of growth ( r < g) generate a free lunch, in the sense that debt sustainability does not require future primary surpluses. We argue that liquidity services provided by sovereign debt may indeed lead to a free lunch, albeit one of limited size. The value of such services depends on the credibility of the central bank, which can be accumulated via prudent policies and subsequently drawn on to allow for looser fiscal policy.

Exchange Rate Pass-Through and Central Bank Credibility: Evidence on Inflation Targeting Countries

Exchange Rate Pass-Through and Central Bank Credibility: Evidence on Inflation Targeting Countries

Sovereign Debt Sustainability and Central Bank Credibility

Sovereign Debt Sustainability and Central Bank Credibility

Central Bank Credibility During COVID-19: Evidence from Japan

Japanese realized and expected inflation has been below the Bank of Japan’s two percent target for many years. We use the exogenous COVID-19 pandemic shock to examine the efficacy of monetary and fiscal policy responses for elevating inflation expectations from an arbitrage-free term structure model of nominal and real yields. We find that monetary and fiscal policy announcements during this period failed to lift inflation expectations, which instead declined notably and are projected to only slowly revert back to levels far below the announced target. Hence, our results illustrate the challenges faced in raising well-anchored low inflation expectations.

The excess sensitivity of long-term interest rates and central bank credibility

Long-term interest rates show considerable reaction to macroeconomic shocks and news. This is, however, difficult to explain using standard rational expectations macro-finance models, as are widely used in policy analyses. In this research, we demonstrate that concerns regarding central bank credibility can account for the excess sensitivity of long-term interest rates, using an estimated macro-finance model that incorporates endogenously evolving perceptions about central bank credibility. In particular, long-term interest rates respond more strongly to macro shocks when credibility is lower. Quantitatively, two thirds of the observed decline in the volatility of U.S. long-term rates after the mid-1990s can be attributed to an increase of credibility in the Fed.

The effect of central bank credibility on forward guidance in an estimated New Keynesian model

AbstractThis paper examines the effectiveness of forward guidance shocks in the US. We estimate a New Keynesian model with imperfect central bank credibility and heterogeneous expectations using Bayesian methods and survey data from the Survey of Professional Forecasters (SPF). The results provide important takeaways: (1) The estimated credibility of the Fed’s forward guidance announcements is relatively high, but anticipation effects are attenuated. Accordingly, output and inflation do not respond as favorably as in the fully credible counterfactual. (2) The so-called “forward guidance puzzle” arises partly from the unrealistically large responses of macroeconomic variables to forward guidance under perfect credibility and homogeneous fully informed rational expectations, assumptions which are found to be jointly inconsistent with the observed US data. (3) Imperfect credibility provides a plausible explanation for the empirical evidence of forecasting error predictability based on forecasting disagreement found in the SPF data. Thus, we show that accounting for imperfect credibility and forecasting disagreements is important to understand the formation of expectations and the transmission mechanism of forward guidance.

Can credibility offset electricity price effect on business confidence? An empirical investigation from a large emerging economy

ABSTRACT We analyse the ‘offsetting effect’ that the central bank credibility can have in mitigating the harmful effects of the increase in electricity price on business confidence. Based on data from the Brazilian economy from 2010 to 2019, we perform several regressions with different specifications and methods, taking into account aggregate level and the eleven industrial sectors with higher electricity consumption. In general, our findings support the view that an increase in electricity price harms business confidence, but there is an ‘offsetting effect’ when central bank credibility increases.

Strategic deviations in optimal monetary policy

This paper investigates the circumstances under which a central bank is more or less likely to deviate from the optimal monetary policy rule. The research question is addressed in a simple New Keynesian dynamic stochastic general equilibrium (DSGE) model in which monetary policy deviations occur endogenously. The model solution suggests that higher future central bank credibility attenuates the current period policy trade-off between a stable inflation rate and a stable output gap. Together with the loss of credibility after a policy deviation, this provides the central bank with an incentive to implement past policy commitments. The result is valid even if the central bank may recover credibility with some probability after a policy deviation. My main finding is that the central bank is willing to implement past policy commitments if a sufficient fraction of agents is not aware of the exact end date of the policy commitment. The result challenges the time-inconsistency argument against monetary policy commitments and provides a potential explanation for the repeated implementation of monetary policy commitments in reality.

Monetary policy rules in practice: The case of Israel

This paper presents a case study of how communication on monetary policy rules in Israel allows for discretionary deviations within a rule-like policy framework without impairment to central bank credibility. We quantitatively analyze a monetary policy rule that has described Bank of Israel policy formally since 2012 and informally since 2007. We demonstrate the value of a policy rule as a tool of communication and show how policymakers leverage this rule in times of economic uncertainty. We identify periods of discretionary deviation from the policy rule and show how communication on financial stability concerns derived from monthly interest rate announcements explains these deviations. Finally, we show how policymakers in Israel were able to anchor market expectations, even in times of great economic uncertainty. We assess how market expectations about the future path of the short-term interest rate respond both to communication related to the rule and exercised flexibility during the financial crisis. We use futures contracts on short term interest rates from the inter-bank market and find that monetary policy predictability improves in the period following the publication of this rule. We argue that policymakers in Israel were able to conduct monetary policy consistent with their main long-term objectives while maintain a high degree of transparency on assessments behind interest rate decisions.

The Effect of Central Bank Credibility on Forward Guidance in an Estimated New Keynesian Model

The Effect of Central Bank Credibility on Forward Guidance in an Estimated New Keynesian Model

Confidence in digital money: Are central banks more trusted than age is matter?

The virtual nature of digital money is fueling the conflict between usability, functionality and trust in the digital form. Institutional trust drivers should move forward in understanding the nature of confidence in digital money. Do central banks digital money (CBDC – central bank digital currency) and private cryptocurrencies demonstrate the same or different trust patterns? The paper used the general regression method to discover the relationship between trust in different forms of digital money and selected variables that may generate this trust. Simple empirical tests were sufficient to find the fundamental importance of age as a confidence driver relevant to CBDC and cryptocurrencies. It is found that traditional factors associated with the inflation history and quality of monetary order (central banks independence and rule of law) do not play a role in the case of CBDC, but are important in the case of cryptocurrencies. Structural features (like FinTech development or social trust) that should support trust in digital money are not found to be important. Societies with larger fraction of younger generations demonstrate higher confidence in centralized and decentralized forms of digital money. This challenges the traditional approach to money and calls into question the future role of monetary stability institutions in the digital age. Digitalization is perceived as an improvement in welfare only when fiat money institutions become fragile. The efficiency and credibility of central banks are not a bonus to confidence in CBDC. This is a challenge for the institutional design of the future digital-based monetary order.

Are Government Bond Yields Bounded or Quasi-Bounded at the Zero? – Credibility of Central Banks' Commitments

This paper develops a model based on a target-zone approach in which the dynamics of government bond yields follow a quasi-bounded process, such that the zero lower bound (ZLB) can be breached if the probability leakage condition of the dynamics is met. A one-sided U-shaped bond yield distribution illustrates accumulation of probability at the ZLB. Allowing the expected return and variance of the market’s return proportional to the square of the state variable governing changes in production and investment opportunities over time suggests the state variable following an asymmetric mean-reverting process with strong counteracting force at the ZLB representing the credibility of the bound committed by a central bank. Empirical calibrations of the proposed process for the US and French government bond yields show that the process can adequately describe their dynamics. While the yields were bounded above the ZLB during most of the time, as indicated by their dynamics, the conditions for breaching the bound were met in January 2013 for the French government bond and March 2020 for the US Treasury using only information until those points. The economic and financial condition uncertainties are negatively co-integrated with the mean reversion in the dynamics, suggesting increased likelihood of the yield breaching the ZLB and erosion of the credibility of the bound amid higher uncertainties.

Clear, Consistent and Engaging: ECB Monetary Policy Communication in a Changing World

This paper examines the importance of central bank communication in ensuring the effectiveness of monetary policy and in underpinning the credibility, accountability and legitimacy of independent central banks. It documents how communication has become a monetary policy tool in itself; one example of this being forward guidance, given its impact on inflation expectations, economic behaviour and inflation. The paper explains why and how consistent, clear and effective communication to expert and non-expert audiences is essential in an environment of an ever-increasing need by central banks to reach these audiences. Central banks must also meet the demand for more understandable information about policies and tools, while at the same time overcoming the challenge posed by the wider public’s rational inattention. Since the European Central Bank was established, the communications landscape has changed dramatically and continues to evolve. This paper outlines how better communication, including greater engagement with the wider public, could help boost people’s understanding of and trust in the Eurosystem. JEL Classification: E43, E52, E58

The Determinants of Price Change: Evidence from a Survey of Firms

Price stability are important for macroeconomic stability, especially for the economies, which are facing macroeconomic instability. Contractionary monetary policy can play an important role in minimizing the frequency of price change, so for effective monetary policy, it is necessary to identify the determinants of price setting behaviour. The objective of the study is to determine the patterns of price setting of firms and responses of firms to economic shocks, i.e. changes in demand and supply side factors, the role of firm characteristics, institutional and other factors in determining the channel of adjustment after these shocks. The data is collected through stratified frandom samplling from 342 firms, located in four Industrial estates of Khyber Pakhtunkhwa. Price setting behavior is measured through importance of demand and cost shocks for price change. To estimate the effects of determinants of price change, models are estimated through logistic technique. Firms’ likelihood of price increases higher than that to price decrease in response to both demand and supply shocks. Furthermore, supply-side factors lead to higher frequency of price change than demand-side factors do. The cost of raw material and cost of energy are the most important causes of price change, both for the price increase and decrease. Demand and cost shocks are important determinants of price change for imperfectly competitive firms, backward-looking firms, firms run by managers having more information about economic conditions, while credibility of central bank is important determinant of price change in case of demand shocks only. Size of firms and information set regarding expected inflation do not have any effect. For effective monetary policy of Pakistan, credibility of central bank has to be established to stabilize prices and pre-emptive measures should be taken on the part of central bank to counter supply shocks.