Few, if any, newspaper columnists are as consistently insightful and challenging as John Kay of the Financial Times. In his column today (“The dogma of ‘credibility’ now endangers stability”), Kay brilliantly demolishes the modern obsession with central-bank credibility, the notion that failing to meet an arbitrary inflation target will cause inflation expectations to become “unanchored,” thereby setting us on the road to hyper-inflation of Zimbabwean dimensions. (Talk about a slippery slope! If only central bankers and Austrians Business Cycle Theorists realized how much they had in common, they would become best friends.)
The elevation of credibility into a central economic has turned a sensible point — that policy stability is good for both business and households — into a dogma that endangers economic stability. The credibility the models describe is impossible in a democracy. Worse, the attempt to achieve it threatens democracy. Pasok, the established party of the Greek left, lost votes to the moderate Democratic Left and more extreme Syriza party because it committed to seeing austerity measures through. Now the Democratic Left cannot commit to that package because it would lose to Syriza if it did. The UK’s Liberal Democrats, by making such a deal, have suffered electoral disaster. The more comprehensive the coalition supporting unpalatable policies, the more votes will go to extremists who reject them.
We got into this mess in 2008, because the FOMC, focused almost exclusively on rising oil and food prices that were driving up the CPI in the spring and summer of 2008, ignored signs of a badly weakening economy, fearing that rises in the CPI would cause inflation expectations to become “unanchored.” The result was an effective tightening of monetary policy DURING a recession, which led to an unanchoring of inflation expectations all right, but in precisely the other direction!
Now, the ECB, having similarly focused on CPI inflation in Europe for the last two years, is in the process of causing inflation expectations to become unanchored in precisely the other direction. Why is it that central bankers, like the Bourbons, seem to learn nothing and forget nothing? Don’t they see that central bank credibility cannot be achieved by mindlessly following a single rule? That sort of credibility is a will o the wisp.