Stephen King: Central banks' credibility no longer built on inflation alone

In a low inflation period, the attractions of hairshirt policies have waned

Central banks spend a lot of their time worrying about credibility. They want to do the right thing and be seen to be doing the right thing. They don't want to give the markets any nasty shocks, preferring to lead them by the hand through the obstacle race that is the global economy.

On this basis, the US Federal Reserve found itself in a bit of a dilemma last week. Having proclaimed mid-year that recovery was on the way, it was suddenly forced into an abrupt U-turn. It couldn't very well cut interest rates immediately. But it could give the markets good reason to think that rate cuts might be in the offing. So it chose to broadcast its new perception that the risks facing the US economy were now weighted more towards "weakness".

The need for credibility has been couched, for the most part, in the context of inflation and inflationary expectations. Have a credible policy, so the argument goes, and you will find it easier to control inflationary expectations because people believe you mean business. Have a flaky approach, perhaps influenced by political pressures, and you may struggle to contain people's worst inflation fears.

Earlier this year, therefore, there seemed to be a "first mover advantage" for those central banks that chose to raise interest rates in response to early signs of cyclical recovery. The Canadians, the Australians, the New Zealanders and the Swedes were first off the blocks. Interest rates went up, seemingly supporting perceptions within financial markets that recovery was underway and that inflationary pressure would not be tolerated. In turn, the actions of these central banks almost certainly contributed to heightened expectations of monetary tightening in other parts of the world.

Initially, the markets liked these robust actions. Higher interest rates suggested confidence in the strength of recovery. And if major basic commodity producers – Canada and Australia – were showing signs of recovery, this could imply good news for the rest of the world as well. These "early birds" were quick to catch the market worm: capital began to flow into their countries, leading to rising exchange rates that seemingly underlined the credibility of their actions.

But the worm now seems to be giving these central banks a bit of an upset stomach. The key problem has been a reversal of the earlier exchange rate strength. The charts show the Canadian and Australian experience: an initial thumbs-up followed by a subsequent vote of no confidence. Ultimately, of course, foreign exchange markets are notoriously fickle and not too much should be read into exchange rate movements over just a few months. The fact remains, however, that the initial desire to tighten monetary conditions through higher interest rates has been partially undone by the impact of the subsequent currency decline.

The lesson to be drawn from this experience may be that policies are credible only to the extent that they reflect the real risks facing an economy and, in addition, the markets' perceptions of those risks. The euro's decline through much of the past three years was, in some ways, rather odd. The European Central Bank was determined to build its anti-inflation credentials and, as a result, pursued a monetary policy that appeared to be geared more to the defeat of inflation than the pursuit of economic growth.

Back in the 1970s and 1980s, this approach would perhaps have been highly valued. In the low inflation period of recent years, however, the attractions of this kind of hairshirt policy have waned. As a result, the attempts to keep inflation lower through a relatively tight domestic monetary policy may have been undermined by persistent falls in the exchange rate as capital left to go to more "pro-growth" countries.

The issue of credibility is, therefore, a lot more complicated than appeared to be the case a few years ago. What might seem to be a credible policy from a central bank perspective may not be credible for markets that choose to dance to a different tune. The market reactions to the interest rate increases seen in Canada, Australia and the others may have differed from expectations precisely because the markets are no longer interested in rewarding anti-inflation policies.

One reason for this may well be that the markets now think – probably with some degree of justification – that inflation control is now a relatively easy affair. After all, it's a lot easier for each country to achieve price stability when everyone else has exactly the same idea.

Indeed, there's an increasing amount of evidence to suggest that countries can run all sorts of different monetary policies without necessarily suffering nasty inflationary consequences, at least in the traditional manner. Over the past decade, the correlation of inflation rates across different countries has been very high, even though the correlation of cost changes across different countries has fallen back a long way. As a result of much more open trade in both goods and, increasingly, services, companies have been under increasing pressure to stick to a global "law of one price" irrespective of their cost levels.

There are two implications that stem from this change. First, monetary mistakes may no longer show themselves up in higher inflation alone and, second, the achievement of low inflation, in itself, may not be sufficient to persuade financial markets that a good job is being done by the monetary authorities.

If true, this could imply some radical new challenges for policy markers. Back in the 1960s, fiscal expansion was seen to be the answer to many a country's failure to grow at the appropriate rate or to achieve the relevant level of employment. By the 1980s, however, that view had gone completely out of fashion, as the French government of that period discovered to its cost. The markets began to exact serious pressure on those economies that failed to adopt the accepted wisdom of the time.

There is mounting evidence to suggest that the control of inflation, on its own, is insufficient to stabilise economic activity. For the most part, Japan managed to control inflation reasonably well in the late-1980s yet that period, of course, laid the foundations for the deflation that has afflicted Japan ever since. Similarly, America's performance on inflation has been very good in recent years yet, as I argued last week, there is now a serious danger of stagnation, whereby the US economy suffers a post-bubble hangover for a prolonged period of time.

If the achievement of low rates of inflation is now relatively easy and if low rates of inflation do not provide a lasting guarantee of economic stability, then we may have reached the stage where markets look a little more quizzically at the actions of central banks engaged in a fight against inflation alone. Undoubtedly, no one wants to see a return to the inflationary world of the 1970s and 1980s. Then again, if those risks are now not so great, markets may think again before awarding glowing accolades to those central banks that carry on the good fight against inflation at the expense of macroeconomic stability over the medium term. The Canadian and Australian examples may not amount to much but they emphasise that there is sometimes a danger of "first mover disadvantage" if the real risks to global economic activity are not centred on the spectre of high inflation.

Stephen King is managing director of economics at HSBC.