<blockquote>
<p>Just look at the eurodollar market. The market is fully capable of finding out the correct rates for itself.</p>
</blockquote>
<p>Is it? As shown in <a href="https://economics.stackexchange.com/a/50265/37817">this answer</a> the Eurodollar rate is more or less entirely driven by the interest set by the FED.</p>
<p>In any case, that is also unrelated to what Bullard refers to. The FED will always be able to influence interest rates. I believe no one questions the ability of the Turkish central bank to change interest rates. However, I believe most people question the ability (willingness) of the Turkish CB to fight inflation.</p>
<p>As the FED <a href="https://www.stlouisfed.org/publications/regional-economist/october-1996/a-recipe-for-monetary-policy-credibility" rel="nofollow noreferrer">states</a>,</p>
<blockquote>
<p>A transparent monetary policy is one in which the central bank clearly
states its commitment to some goal—in this case achieving price
stability—and how it intends to get there. Credibility is attained
when the central bank's actions are consistent with reaching this
goal.</p>
</blockquote>
<p>Now look at a chart of CPI vs FFR. (<a href="https://fred.stlouisfed.org/series/CPIAUCSL" rel="nofollow noreferrer">CPIAUCSL</a> and <a href="https://fred.stlouisfed.org/series/FEDFUNDS" rel="nofollow noreferrer">FEDFUNDS</a> from FRED).
<a href="https://i.sstatic.net/XNiEn.png" rel="nofollow noreferrer"><img src="https://i.sstatic.net/XNiEn.png" alt="enter image description here" /></a></p>
<p>The FED story so far was that we should see inflation start to subside. However, there was not the slightest hint of that in the January data because CPI rates came in stronger than expected.</p>
<p>The Central Bank’s credibility is an important feature in the implementation of monetary policy strategies because a CB's ability to control inflation dynamics
depends largely on its power to manage inflationary expectations. The higher the Central Bank’s credibility level, the more power to implement counter-cyclical monetary policies without measures that are destabilizing the economy.
<br> <br>
As you can see in the chart, there was a period of &quot;Great Inflation&quot; ending with Paul Volker's appointment as chairman of the Fed (he took office on August 6, 1979). Volker reduced inflation dramatically, but at substantial cost to employment and growth. The FED's credibility in terms of its commitment to fight inflation increased significantly with Volker.</p>
<p>The last time we saw inflation rates like the latest measure was back in 1982, or 40 years ago.
<a href="https://i.sstatic.net/1fcge.png" rel="nofollow noreferrer"><img src="https://i.sstatic.net/1fcge.png" alt="enter image description here" /></a></p>
<p>If you now believe that interest rates have an impact on inflation, having rates near zero, while inflation is above 7% is not exactly a credible effort to fight inflation. So far, people believed the FED and inflation expectations are still moderate, as can be seen in the <a href="https://fred.stlouisfed.org/series/T5YIFR" rel="nofollow noreferrer">5-Year, 5-Year Forward Inflation Expectation Rate </a> for example. If you are unsure what this is, you may have a look at this <a href="https://quant.stackexchange.com/a/65713/54838">explanation</a>.</p>
<p>One way to measure credibility is by looking at how closely inflation expectations match the central bank's inflation target (Demertzis et al. 2012).  The closer, the more credible. Thomas J. Sargent (1982) showed that (under rational expectations), a fully credible CB can engineer disinflation without causing adverse effects on employment.</p>
<p>Long story short:</p>
<ul>
<li>you can measure credibility by looking at inflation expectations vs a central bank's inflation target</li>
<li>worst case: bringing down inflation will result in very high unemployment rates and cause more pain to the John &amp; Jane Doe's of America</li>
</ul>

CC BY-SA 4.0
2022-02-16T02:07:01.937Z
2022-02-16T02:07:01.937Z
AKdemy
<blockquote>
<p>Is there a theoretical basis for a worst-case scenario if the Fed lost its &quot;credibility?&quot;</p>
</blockquote>
<p>The worst case scenario is that Fed will loose access to important policy tools such as forward guidance.</p>
<p>Presently Fed can move interest rates and market expectations just by talking about its policy because generally Fed is perceived as credible. For example, Fed stating it will keep interest rates low longer than necessarily can provide additional stimulus to the economy now even if Fed cannot change interest rate because maybe it already hit zero lower bound or for other reasons (<a href="https://voxeu.org/system/files/epublication/forward_guidance.pdf" rel="nofollow noreferrer">den Haan 2013</a>).</p>
<p>If Fed looses its credibility such policy tricks will become impossible to pull off. If nobody will believe Fed will actually stick to its plan people will only react to actual verifiable policies such as Fed funds rate change.</p>
<blockquote>
<p>I tried to counter by saying, we might run into regulatory capture if the market perceives the Fed as a entity that can be gamed (everybody sell and wait for the Fed capitulation) rather than a fair arbiter of policy. My colleague wasn't very convinced</p>
</blockquote>
<p>I am not surprised your colleague wasn’t convinced by this. Credibility has not much to do with regulatory capture. Central bank can be credible and also be captured by special interest or it might lack credibility and not be captured.</p>
<p>Regulatory capture is situation when the institution that is charged with regulation gets corrupted and instead of promoting public interest it promotes interests of entities it is supposed to be regulating (eg see <a href="https://www.tobinproject.org/sites/tobinproject.org/files/assets/Introduction%20from%20Preventing%20Regulatory%20Capture.pdf" rel="nofollow noreferrer">Carpenter and Moss 2014</a>). Gaming the system like for example exploiting various loopholes in regulatory systems is not capture per se unless the loopholes were put in place by the regulator intentionally. Optimal profit maximizing response to regulations or policies of government is not capture.</p>
<p>An example of regulatory capture of Fed would be setting its bank regulation in a way that maximizes bank profitability as opposed to reducing macro or micro prudential risk. Fed could have zero credibility and still effectively regulate in favor of public interest by promoting bank stability or it can be credible but implement policies that promote bank profitability.</p>

CC BY-SA 4.0
2022-02-15T10:45:03.170Z
2022-02-15T10:45:03.170Z
1muflon1
<p>With Bullard <a href="https://www.cnbc.com/2022/02/14/bullard-say-the-fed-needs-to-front-load-tightening-because-inflation-is-possibly-accelerating.html" rel="nofollow noreferrer">recently stating</a>:</p>
<blockquote>
<p>“Our credibility is on the line here and we do have to react to the
data,” he added. “However, I do think we can do it in a way that’s
organized and not disruptive to markets.”</p>
</blockquote>
<p>I had recently discussed this with a colleague briefly at a meeting, summarizing his points here:</p>
<p>The Fed's reigns on the economy are underpinned by its ability to control/influence lending rates
What is even at stake if the Fed lost credibility? Just look at the eurodollar market. The market is fully capable of finding out the correct rates for itself.</p>
<p>I tried to counter by saying, we might run into regulatory capture if the market perceives the Fed as a entity that can be gamed (everybody sell and wait for the Fed capitulation) rather than a fair arbiter of policy. My colleague wasn't very convinced. And I think I was also not sure if I took the scenario toward its logical conclusion.</p>
<h2>Question</h2>
<p>Is there a theoretical basis for a worst-case scenario if the Fed lost its &quot;credibility?&quot; I concede it's somewhat hard to quantify &quot;credibility,&quot; but realistically speaking, surely the track record would catch up to them, buy/sell-side reports and media coverage with key-words could serve as proxy.</p>

<monetary-policy><federal-reserve>
What is the worst potential outcome if the Fed "loses credibility?"
Arash Howaida
# What is the worst potential outcome if the Fed "loses credibility?"

(Asked by: username_0 on 2022-02-15)

With Bullard [recently stating](https://www.cnbc.com/2022/02/14/bullard-say-the-fed-needs-to-front-load-tightening-because-inflation-is-possibly-accelerating.html):

> “Our credibility is on the line here and we do have to react to the
> data,” he added. “However, I do think we can do it in a way that’s
> organized and not disruptive to markets.”

I had recently discussed this with a colleague briefly at a meeting, summarizing his points here:

The Fed's reigns on the economy are underpinned by its ability to control/influence lending rates
What is even at stake if the Fed lost credibility? Just look at the eurodollar market. The market is fully capable of finding out the correct rates for itself.

I tried to counter by saying, we might run into regulatory capture if the market perceives the Fed as a entity that can be gamed (everybody sell and wait for the Fed capitulation) rather than a fair arbiter of policy. My colleague wasn't very convinced. And I think I was also not sure if I took the scenario toward its logical conclusion.

## Question

Is there a theoretical basis for a worst-case scenario if the Fed lost its "credibility?" I concede it's somewhat hard to quantify "credibility," but realistically speaking, surely the track record would catch up to them, buy/sell-side reports and media coverage with key-words could serve as proxy.

**Tags:** monetary-policy, federal-reserve


---

## 2 answers

### Answer by username_1 on 2022-02-16. Score: 2 | Accepted answer

> Just look at the eurodollar market. The market is fully capable of finding out the correct rates for itself.

Is it? As shown in [this answer](https://economics.stackexchange.com/a/50265/37817) the Eurodollar rate is more or less entirely driven by the interest set by the FED.

In any case, that is also unrelated to what Bullard refers to. The FED will always be able to influence interest rates. I believe no one questions the ability of the Turkish central bank to change interest rates. However, I believe most people question the ability (willingness) of the Turkish CB to fight inflation.

As the FED [states](https://www.stlouisfed.org/publications/regional-economist/october-1996/a-recipe-for-monetary-policy-credibility),

> A transparent monetary policy is one in which the central bank clearly
> states its commitment to some goal—in this case achieving price
> stability—and how it intends to get there. Credibility is attained
> when the central bank's actions are consistent with reaching this
> goal.

Now look at a chart of CPI vs FFR. ([CPIAUCSL](https://fred.stlouisfed.org/series/CPIAUCSL) and [FEDFUNDS](https://fred.stlouisfed.org/series/FEDFUNDS) from FRED).
[![enter image description here](https://i.sstatic.net/XNiEn.png)](https://i.sstatic.net/XNiEn.png)

The FED story so far was that we should see inflation start to subside. However, there was not the slightest hint of that in the January data because CPI rates came in stronger than expected.

The Central Bank’s credibility is an important feature in the implementation of monetary policy strategies because a CB's ability to control inflation dynamics
depends largely on its power to manage inflationary expectations. The higher the Central Bank’s credibility level, the more power to implement counter-cyclical monetary policies without measures that are destabilizing the economy.
  
   
As you can see in the chart, there was a period of "Great Inflation" ending with Paul Volker's appointment as chairman of the Fed (he took office on August 6, 1979). Volker reduced inflation dramatically, but at substantial cost to employment and growth. The FED's credibility in terms of its commitment to fight inflation increased significantly with Volker.

The last time we saw inflation rates like the latest measure was back in 1982, or 40 years ago.
[![enter image description here](https://i.sstatic.net/1fcge.png)](https://i.sstatic.net/1fcge.png)

If you now believe that interest rates have an impact on inflation, having rates near zero, while inflation is above 7% is not exactly a credible effort to fight inflation. So far, people believed the FED and inflation expectations are still moderate, as can be seen in the [5-Year, 5-Year Forward Inflation Expectation Rate](https://fred.stlouisfed.org/series/T5YIFR)  for example. If you are unsure what this is, you may have a look at this [explanation](https://quant.stackexchange.com/a/65713/54838).

One way to measure credibility is by looking at how closely inflation expectations match the central bank's inflation target (Demertzis et al. 2012). The closer, the more credible. Thomas J. Sargent (1982) showed that (under rational expectations), a fully credible CB can engineer disinflation without causing adverse effects on employment.

Long story short:

* you can measure credibility by looking at inflation expectations vs a central bank's inflation target
* worst case: bringing down inflation will result in very high unemployment rates and cause more pain to the John & Jane Doe's of America


---

### Answer by username_2 on 2022-02-15. Score: 2

> Is there a theoretical basis for a worst-case scenario if the Fed lost its "credibility?"

The worst case scenario is that Fed will loose access to important policy tools such as forward guidance.

Presently Fed can move interest rates and market expectations just by talking about its policy because generally Fed is perceived as credible. For example, Fed stating it will keep interest rates low longer than necessarily can provide additional stimulus to the economy now even if Fed cannot change interest rate because maybe it already hit zero lower bound or for other reasons ([den Haan 2013](https://voxeu.org/system/files/epublication/forward_guidance.pdf)).

If Fed looses its credibility such policy tricks will become impossible to pull off. If nobody will believe Fed will actually stick to its plan people will only react to actual verifiable policies such as Fed funds rate change.

> I tried to counter by saying, we might run into regulatory capture if the market perceives the Fed as a entity that can be gamed (everybody sell and wait for the Fed capitulation) rather than a fair arbiter of policy. My colleague wasn't very convinced

I am not surprised your colleague wasn’t convinced by this. Credibility has not much to do with regulatory capture. Central bank can be credible and also be captured by special interest or it might lack credibility and not be captured.

Regulatory capture is situation when the institution that is charged with regulation gets corrupted and instead of promoting public interest it promotes interests of entities it is supposed to be regulating (eg see [Carpenter and Moss 2014](https://www.tobinproject.org/sites/tobinproject.org/files/assets/Introduction%20from%20Preventing%20Regulatory%20Capture.pdf)). Gaming the system like for example exploiting various loopholes in regulatory systems is not capture per se unless the loopholes were put in place by the regulator intentionally. Optimal profit maximizing response to regulations or policies of government is not capture.

An example of regulatory capture of Fed would be setting its bank regulation in a way that maximizes bank profitability as opposed to reducing macro or micro prudential risk. Fed could have zero credibility and still effectively regulate in favor of public interest by promoting bank stability or it can be credible but implement policies that promote bank profitability.


---

