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“Central Bank Credibility: Myths and Realities”
Summary of Remarks by
Brian Sack
Deputy Director, Monetary Policy Insights
Macroeconomic Advisers, LLC
February 22, 2007
Dr. Sack discussed the process through which the Federal Reserve anchors long-term inflation expectations and he addressed the often-cited claim that those expectations can be easily dislodged. He focused his presentation on the substantial implications of Federal Reserve credibility for both the economy and financial markets, raising the possibility that anchored expectations could account for much of the observed decline in risk premiums and expected volatility.
Dr. Sack used a slideshow of charts with financial themes and figures of numerical data to clarify his presentation. The first slide defined Federal Reserve credibility as having long-term inflation expectations “anchored” at a low level. According to the slide show, we should realize that inflation will vary with incoming shocks, but that a credible central bank would be expected to return inflation to its desired level over time. Dr. Sack explained that currently expectations appear “well anchored,” but that there is “considerable uncertainly about the dynamics of expectations.” One advantage of a credible central bank is that its anchored expectations help to stabilize the national economy. As a result, better anchored central bank credibility can explain much of the decline in term premiums and volatility.
In fact, one implication of the credibility of the central bank, Dr. Sack argued, is that movements in inflation become more transitory, and inflation becomes more self-equilibrating. With high central bank credibility, output can become more stable, with better tradeoff between inflation and output, more aggressive policy responses to output, and a greater moderation effect. He presented a Price-Price Phillips curve that directly incorporates a measure of expectations, which we can see on the NEC website slideshow. In that equation, long-term expectations of inflation are found to exert a gravitational pull on realized inflation. Expectations “anchored at 2%,” have the gravitational effect to cause impulses to inflation to be more transitory. In sum, Dr. Sack concluded that the credibility of the bank appears robust rather than fragile, that the fragile credibility of the U.S. central bank is more myth than reality, and that this credibility has substantial implications in stabilizing the economy.
In the Q & A period, a member of the audience raised a question about his use of the Phillips Curve, which the member thought less valuable than measures of direct signaling. Dr. Sack answered that the Phillips curve, while imperfect, is still the best model that we have.
In September 2004, Dr. Brian Sack joined Macroeconomic Advisers, LLC, a firm that gives analysis and discussion of Federal Reserve policy to large and active participants in the U.S. fixed income markets. Macroeconomic Advisers is also one of the leading forecasters of the U.S. economy. Its analytical leadership on short-term and fundamental U.S. trends is relied upon by a varied group of clients. Previously Dr. Sack spent 7 years on the staff of the Board of Governors of the Federal Reserve. He received his PhD in economics from the Massachusetts Institute of Technology in 1997. Several days after the NEC presentation, the Wall Street Journal mentioned Dr. Sack and his ideas in an article “Policy Makers at Fed Rethink Inflation’s Roots,” available to subscribers at:
http://online.wsj.com/article/SB117245624842818971
His lunch slideshow and our podcast of his talk (NEC Podcast #6) are available online.
Rapporteur: Harold Brown
