CREDIBILITY AND MONETARY POLICY: THEORY AND EVIDENCE1
| Date | 01 February 1995 |
| DOI | http://doi.org/10.1111/j.1467-9485.1995.tb01142.x |
| Published date | 01 February 1995 |
| Author | Mervyn King |
Scomjh
Jouml
of
Political
Economy.
Vol.
42,
No.
I.
February
1995
Q
Scottish
Economic
Socicty
1595. Published
by
Blaclrwcll
Publishers. 108
Cowley
Road,
Oxford
OX4
IJF,
UK
and
238
Main
Slrut.
Cambridge.
M.402142.
USA
CREDIBILITY AND MONETARY POLICY:
THEORY AND EVIDENCE’
Mervyn King
I
INTRODIJCIION
It is a great honour to be invited to deliver the first Scottish Economic
Society/Royal Bank of Scotland Lecture.
In
the very first issue of the
Scottish
Journal
of
Political
Economy
in March
1954,
Sir Alec Caimcross, writing about
the reconstitution
of
the Scottish Economic Society, referred to the conse-
quences of putting oneself at the mercy
of
a Scottish audience which ‘has an
extremely limited appetite for any lengthy analysis of general economic and
social issues unless it has an obvious and immediate bearing on his personal
affairs’.
I
have taken
this
advice to heart.
I
shall
try
to be brief and I shall
talk
about interest rates.
Since the beginning
of
this
year bond rates in the
UK
have risen by about
200
basis points. The increase over the past twelve months has been less-some
140
basis points. Nevertheless, the rise has been considerable, and has occurred,
to varying degrees,
in
all industrialised countries. What does
this
tell
us
about monetary policy
in
the
UK?
In
that same article Alec Caimcross wrote
that Scottish economists rejoiced
in
‘the old-fashioned description ‘‘political
economy”, with its concrete approach and canvas’.
I
want tonight to relate these
increases in interest rates to the credibility of monetary policy in the
UK,
a
subject which, because
it
relates to the interaction between govenunent and the
private sector, does,
I
believe, qualify
as
political economy.
Few words trip more readily
off
the lips of central bankers than ‘credibility’.
Words are important. Every profession has them, and central banking
is
no
exception. Indeed, a journalist recently described credibility as the ‘new mantra
of the mandarins’, and argued that credibility dominates official thinking in the
UK
to
such
an
extent that other objectives have been relegated to second place.
This
view does,
I
believe, misrepresent not only the role
of
credibility in
monetary policy but also the ability
of
monetary stimulation to solve the
sbvctural problems of the
UK
economy.
As
my newsagent
said
the other
morning, ‘newspapers, you can’t trust them-they’re in the hands of the
media’.
But is credibility any more than a word or a mantra?
As
the
King
of
Denmark put it in Hamlet, ‘words without thoughts never to heaven
go’
(Hamlet,
III.3.97).
So
I
want to organise my lecture around three questions.
’The first Scottish
Economic
Society/Royal
Bank
of
Scotland
Lecture,
delivered
in
Edinburgh, Monday
24
October,
1994:
the thirtieth in the Society’s
Annual
Lecture
Series.
*
Bank
of
England
1
2
MERVYN
KING
First, what is credibility? Second, why does it matter? And, third, is it possible
to measure it?
n
THE
CONcEpr
OF
CFGDIBILITY
The Oxford English Dictionary describes ‘credibility’ as a mid-sixteenth
century word meaning the quality of being credible, or believable, or having a
good reputation. In the context of monetary policy credibility has a precise
meaning. A monetary strategy-a plan of future policy actions contingent upon
events-is credible if the public believes that the government will actually
cany out its plans. Credibility is, therefore, a question of whether
announcedintentions
are
believable.
This
could
be
a matter of trust. But
markets, and for that matter, voters, are naturally suspicious. The announced
intentions
are
much more credible if there are incentives to pursue the stated
course of action. A future monetary policy action is credible if it is in the
interest of the monetary authorities to enact
this
policy when the time comes.
Hence policy is credible when the authorities’ actions are, as economists put it,
‘time consistent’, that is the authorities have no incentive to deviate from their
original intentions.
This
is not a question of trust-read my lips: no more
inflation-but of whether the monetary authorities face an
incentive
to pursue
low inflation.
One way of trying to achieve time consistency is to precommit to a fixed
rule-for example, set interest rates
so
that some measure of the money supply
grows at a constant rate each year. It is well known that such rules
are
sub-
optimal. From time to time, shocks occur which mean that the optimal growth
rate of the money supply changes.
To
refuse to respond to those shocks may
enhance credibility in the policy rule, but only at the expense of sensible policy
adjustments. When the shocks
are
sufficiently frequent and large, as they have
been
in most countries, the rule becomes discredited and is, literally, incredible.
No
rule for monetary policy has been discovered which could credibly
be
followed. It is inevitable, therefore, that, as Henry Simons argued in
1936,
monetary policy ‘must rely on a large element of discretion’.
But there is a problem with a purely discretionary monetary policy. The
ability of the authorities to spring monetary surprises on an unsuspecting public
allows them to exploit the short-term trade-off between inflation and output to
achieve temporarily higher output. Anticipating
this
reaction, economic agents
in the private sector come to expect inflation and
to
build such expectations into
their wage and price-setting behaviour. Inflation will rise to a level beyond
which the authorities will not choose to spring further inflation surprises, and
the result of
this
‘game’ between public and private sectors is an inbuilt inflation
bias to policy. At this equilibrium inflation rate the marginal cost of additional
inflation is equal to the marginal gain from higher output in the short term
resulting from the inflation surprise. Although the recent analysis of the inflation
bias, as in the pioneering work of Robert Barro and David Gordon
(1983).
is
based on developments in game theory for which the Nobel
Prize
was awarded
in
1994,
the idea can
be
found
in
the writings of the mentor of the Scottish
0
Scottish
Emnunic
Society
1995
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