Catastrophic Credibility
By Paul Krugman
A little while ago Ben Bernanke responded to suggestions that the Fed needed to do more — in particular, that it should raise the inflation target — by insisting that this would undermine the institution’s “hard-won credibility”. May I say that what recent events in Europe, and to some extent in the US, really suggest is that central banks have too much credibility? Or more accurately, their credibility as inflation-haters is very clear, while their willingness to tolerate even as much inflation as they say they want, let alone take some risks with inflation to rescue the real economy, is very much in doubt.
Yesterday I pointed to the German breakeven, a measure of euro area inflation expectations, which has plunged lately. Here’s a longer view:
Note the peak in April 2011. It wasn’t very high; slightly above the ECB’s target, but arguably still too low to make the needed adjustment within the euro area feasible. Nonetheless, the ECB raised rates — and that was when the euro really began falling apart. The direct effects of the rate increase can’t explain that unraveling, but the effect on expectations — aha, so they really are that fanatical about price stability! — can.
Now the breakeven is plunging. I’d like to think that the ECB is holding frantic meetings and planning to announce a surprise sharp rate cut, preferably to zero, the day after tomorrow. But I doubt it. The fact is that the ECB is highly credible: most observers, me included, are quite sure that it is totally allergic to inflation and relatively indifferent to the collapse of the real economy.
The Fed has conveyed a milder form of the same message, issuing forecasts that show inflation slightly below target and unemployment far above target; given its dual mandate, this should be a flashing siren calling for more action. Yet these forecasts have been accompanied by statements to the effect that no action is currently called for. The Fed has therefore created the credible expectation that it will move only if inflation is far below the claimed target, and doesn’t really care about unemployment.
My earnest hope is that both central banks will rethink the meaning of credibility, and in particular what kind of credibility they really want to have, very soon. And by very soon I basically mean tomorrow.
And my response:
RGDanon
Greece
Yesterday I pointed to the German breakeven, a measure of euro area inflation expectations, which has plunged lately. Here’s a longer view:
Now the breakeven is plunging. I’d like to think that the ECB is holding frantic meetings and planning to announce a surprise sharp rate cut, preferably to zero, the day after tomorrow. But I doubt it. The fact is that the ECB is highly credible: most observers, me included, are quite sure that it is totally allergic to inflation and relatively indifferent to the collapse of the real economy.
The Fed has conveyed a milder form of the same message, issuing forecasts that show inflation slightly below target and unemployment far above target; given its dual mandate, this should be a flashing siren calling for more action. Yet these forecasts have been accompanied by statements to the effect that no action is currently called for. The Fed has therefore created the credible expectation that it will move only if inflation is far below the claimed target, and doesn’t really care about unemployment.
My earnest hope is that both central banks will rethink the meaning of credibility, and in particular what kind of credibility they really want to have, very soon. And by very soon I basically mean tomorrow.
And my response:
Authorities have three choices:
1- Go through many years of austerity and or growth enhancing policies to reduce both deficits and debt to sustainable levels a very long process of perseverence.
2-Central banks abandon their narrow mindedness and allow inflationary EXPECTATIONS (it is this variable expectations, that is important to trigger demand side incentives)
3-Even more importantly design a process to redistribute wealth to households by increasing motgage debt forgiveness and thus wealth, allowing for increased final demand as net worth and prosperity values rise.
In summary, it is a function of transfering wealth from creditors to debtors. If this process is not accelerated then it will be imposed by market forces and or political and ultimately social repercussions. This effectively, is what is currently happening in Greece.
It goes without saying that a combination of all is also another desirable mix.
1- Go through many years of austerity and or growth enhancing policies to reduce both deficits and debt to sustainable levels a very long process of perseverence.
2-Central banks abandon their narrow mindedness and allow inflationary EXPECTATIONS (it is this variable expectations, that is important to trigger demand side incentives)
3-Even more importantly design a process to redistribute wealth to households by increasing motgage debt forgiveness and thus wealth, allowing for increased final demand as net worth and prosperity values rise.
In summary, it is a function of transfering wealth from creditors to debtors. If this process is not accelerated then it will be imposed by market forces and or political and ultimately social repercussions. This effectively, is what is currently happening in Greece.
It goes without saying that a combination of all is also another desirable mix.
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