Low Central Bank Credibility and Low r*
A further follow-up on Vice-Chair Fischer’s January 3 speech …
Why has r* fallen so much and stayed so low, despite signs of improvement in the economy? One reason is the diminished credibility of central bank objectives.
Laubach and Williams (2015) (LW) estimate that r* has fallen by about two percentage points since 2007. They ascribe about 1/2 of this decline to a decline in potential growth. They ascribe about 1/2 of the decline to “other factors”. Below, I argue that one of these factors is diminished central bank credibility.
LW estimate r* as the real interest rate that would prevail in the absence of undue inflationary or disinflationary pressures. But this value conceptually depends on the public's perceptions of the central bank’s ability and/or willingness to hit its objectives.
Suppose that households and businesses believe that, even after the economy ‘normalizes” in five to ten years, they will face a material risk that at some future date the economy will fall short of the Fed’s employment and inflation objectives. Perhaps this belief is because of the zero lower bound. Perhaps this belief is because of perceptions of the Fed’s fear of financial instability associated with low interest rates. Perhaps this is because the Fed is perceived to be scared of using asset purchases. The cause doesn’t matter.)
That risk means that, at any given interest rate, households have a lower demand for consumption and businesses have a lower desire to invest. (That is, the IS curve shifts to the left.) There will be a lower (possibly much lower) real interest rate consistent with the absence of untoward inflationary or disinflationary pressures.
The Fed (and other central banks) have fallen short of their inflation and employment goals for many years, and are expected to do so for several more years to come. The public’s beliefs about Fed long-run capabilities and objectives are evolving in response to these misses. It should not be surprising that the Fed's extended misses with respect to its objectives are fueling expectations of similar future extended misses - and are one factor that is pushing down on r*.
This analysis seems like yet another argument against the plan to continue to tighten monetary policy. Doing so only serves to prolong the Fed’s long undershoot with respect to inflation and (more arguably) with respect to employment. The additional erosion of credibility will create still more downward pressure on r*.
N. Kocherlakota
Rochester, NY, 1/4/16
Follow me on Twitter @kocherlakota009. Please address media enquiries and non-academic speaking requests to Monique Patenaude (monique.patenaude@rochester.edu and 585-276-3693)