Central Bank Credibility: What Does It Mean?

For at least a couple of years before the Great Financial Crisis, policymakers often cautioned that investors were mispricing risk. Through the crisis, investors became painfully aware of many risks, including counterparty risk and reputation risk. Now many observers are highlighting a new risk, what they call the credibility of central banks.  

The issue is that many central banks are nowhere close to reaching their inflation targets.  ECB President Draghi seems to agree. The ECB has a 2% inflation target. The Survey of Professional Forecasters and the ECB’s own staff has been revising their forecasts lows. Draghi has argued that if the central bank does not make more effort to reach its target, it will lose credibility.  

Last October, the Financial Times argued that the BOJ’s credibility was on the line. It either had to expand its aggressive, unorthodox monetary policy, or it had to accept that its policies weren’t working. As we know the Bank of Japan did neither, though in December, it announced some largely technical adjustments its operations, ostensibly to help sustain its asset purchases. It did increase the ETF purchases, but this was to offset the equity sales it was doing to facility the unwinding of cross-shareholdings by the banks.   

It is hard to demonstrate that the BOJ lost credibility. The 10-year JGB yield is about 10 bp lower since the October BOJ meeting, and the yen is the strongest currency (major and emerging market) since then.

Now some observers are arguing that given the weak growth and lack of progress toward its target the BOJ will lose credibility if it does not ease at this week’s meeting. We expected the BOJ to recognize that CPI, excluding fresh food, is likely to be lower than it previously thought in the fiscal year that begins April 1. The economy itself is struggling to sustain even the weakest of expansions. A loss of credibility sounds dire, but what does it really mean for investors? How can it be measured?