Outside world to central banks: 'I don't believe you'

Credibility of the outside world is a central bank's most valuable asset. It is a kind of goodwill that cannot be found on the balance sheet.

Credibility is very valuable to a central banker. The more credible a central bank is, the more effective its policy. With high credibility, you as a central bank, for example, need to actually do less to achieve the desired result, for example to lower inflation. If a credible central bank says that inflation will be better than expected in the long term, there is little chance that companies - in anticipation of high inflation - will raise prices or raise wage demands from unions. With low credibility, as a central bank you are already behind in advance. For example, to get the high inflation back in the box, you have to raise interest rates even more to convince the outside world that you are serious. That extra increase in interest rates can of course cause economic damage.

Credibility in a period of high uncertainty
Credibility is always very valuable to a central bank. But certainly in a period of high uncertainty in the world, for example about the course of inflation in the years to come. In other words: in periods like now. We can deduce the state of that credibility, for example, if we look at what a central bank says it will do and what the financial markets expect it to do. Take the Fed, the American central bank.

It has been saying for some time that it will raise interest rates above 5% this year and will then keep that interest rate at that level throughout the year. But all the while, the market is pricing in a scenario where the Fed goes to that 5% (in the first half of the year), but ends the year at 4,25%. Almost a percentage point difference is quite a bit. The Fed expects inflation in the US to reach 3,1% this year; in the market, the currency devaluation tends more towards somewhere between 3,5 and 4%. Even then you can see that the market does not believe the Fed.

In 2024, the inflation problem will disappear
In the eurozone, the European Central Bank (ECB) expects inflation to return to around 2024% in 2, meaning that the inflation problem will have disappeared. But residents of the eurozone expect prices to rise by 2024% per year in 2025 and 3. In other words, they don't really believe the central bank. The credibility of central banks has fallen quite a bit in recent years, before in the case of the ECB. A major reason for this is that in 2021 and part of 2022 they downplayed inflation that was high and rising.

The danger of all this is that central banks may have a tendency to raise interest rates unnecessarily and thus cause economic damage in the short term. Or that, for example, if economic growth turns out to be low, they will indeed stop raising interest rates sooner than they have indicated time and time again. As a result of which the outside world can say: see, they cannot be trusted. We've always said that. Speaking of trust and credibility in the ECB: it appears that it is not only the outside world that questions it, the same applies to its own staff. This was revealed this week in a survey of central bank employees. Two-thirds of those surveyed say confidence in the bank's board has fallen since 2019. Just under half say they have a fair amount or a lot of confidence in the leadership qualities of Christine Lagarde (pictured) and her board.

Workers do not pay for high inflation
What's bothering the ECB people the most? The high inflation and that the ECB cannot get it under control. With wage growth lower than inflation, ECBers are concerned about their purchasing power. Employees of the ECB constantly hear the board talk, in lectures and interviews, about the need to contain wage increases. While they believe that working people, including themselves, should not have to pay for high inflation. Caused in part by their own employer, if you ask me.

Edin Mujagic

Edin Mujagić is an economist and manager at Beleggingsfonds Hoofbosch. He focuses on global central banks, and in his blogs he writes mainly about developments in interest rates and inflation. He has also written several books.

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