What is Credibility?

There are two ways that credibility may be ascertained, by reputation or by consequence.

If a person has a history of telling the truth, then it is most likely that if he promises, his promise is going to hold some credibility. That is credibility by reputation. Another angle (by inference), would be if the person is known to have a particular ideology, firm ambition, preference or condition. For example, if A is known to have a dairy allergy, then if he promises to never ever eat any ice-cream, then this promise too, holds credibility because his promise aligns with his self-interest or self-protection.

If a person signs a legally binding contract that says should he break his promise he would have to pay a certain sum, then that promise would have credibility by consequence. If the person doesn’t sign a contract but understands that he stands to lose more than what he would gain by breaking the promise, then that promise should hold some credibility. If his measure of gain and loss has a stochastic nature though, then his promise should hold much less credibility.

Can credibility be ascertained by the person promising, by the significance of the promise itself, or must credibility be weighed by how the promised view the worth of the promissory vehicle?

Apart from deciding which scale to use for measuring, it is worth questioning that once credibility is measured, does it have an economic value? Can one derive an advantage from the possession of it, or alternatively, does one gain benefit from the ability to rely on it?

Time and historical consistency, a record of a long line of upheld promises, build credibility. What else can build it? And does one begin by an initial allocation of credibility in gratis?

What can destroy it? What is the cost of having negative credibility? Does prejudice allocate a default negative credibility?

When it comes to policy makers, from “A Theory of Ambiguity, Credibility, and Inflation under Discretion and Asymmetric Information” by Alex Cukierman and Allan H. Meltzer,

Credibility is defined as the absolute value of the difference between the policymaker’s plans and the public’s beliefs about those plans. The smaller this difference, the higher the credibility of planned monetary policy. Credibility is relatively low when governmental objectives undergo large changes. In addition it is lower on average the longer it takes the public to recognize a change in governmental objectives.

In 2006, Janet Yellen as the President and CEO of the Federal Reserve Bank of San Francisco gave a speech entitled, “Enhancing Fed Credibility“, where she said,

To my mind, credibility is a worthy end in itself—those who are credible are often said to be “as good as their word.” But credibility is not only virtuous; it is also useful. I will argue that one of its most important benefits is shaping public expectations about inflation, and in particular, “anchoring” those expectations to price stability. As a consequence, credibility enhances the effectiveness of monetary policy which, in turn, serves a second “worthy end,” namely, maximizing the nation’s economic well-being.

To give you a brief overview of the argument, the idea is that, with credibility, the Fed and the public work together toward the same goals. When this happens, one often hears the phrase “the markets do all the work of monetary policy,” meaning that market participants correctly anticipate the actions that the Fed will make in response to economic news and shocks. This alignment of the Fed’s actions and the public’s expectations strengthens the monetary policy transmission mechanism and shortens policy lags. In contrast, in the absence of credibility, policymakers and the public may work at cross-purposes, and monetary policy must act to overcome and dislodge expectations that hinder the achievement of our goals. Indeed, as I will discuss more fully in a few minutes, this is exactly what happened in the 1970s in the United States.

Credibility is all about what the public expects the Fed will do in the future. Indeed, macroeconomic theory teaches us that expectations of future economic developments play a prominent role in all aspects of economic decision-making. For example, consumption theory tells us that consumer spending depends on one’s permanent income, that is, the present value of expected future income. Similarly, bond yields depend on expected future short-term interest rates. The list goes on and on. Of critical importance for the successful conduct of monetary policy, economic theory tells us that prices set today depend on the inflation rate expected in the future. Therefore, it is only when the Fed’s commitment to low inflation is credible that people will expect low inflation in the future and set prices accordingly. Clearly, then, expectations of future inflation play a central role in our analysis of the economy and in our policy deliberations.

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Because the Fed has been consistent in its approach, over time, market participants have come to observe its reaction to news and therefore better understand the determinants of policy. Therefore, this approach has enhanced the ability of financial markets to anticipate the policy response to economic developments.

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In theory, effective central bank communication of a numerical long-run inflation objective to the public can simplify the complicated informational problems people face in the economy, and can reduce the uncertainty about the central bank’s goals and policies. Indeed, recent research suggests that clear communication of a numerical long-run inflation objective may assist in the anchoring of long-run inflation expectations, relative to a policy that leaves it to the public to infer the objective from experience.

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Recent research highlights the ways in which central bank communication can improve the public’s ability to predict policy actions, and how this improvement can enhance the effectiveness of policy at stabilizing the economy. The key insight of this research is that the central bank has useful knowledge about the likely direction of the economy and monetary policy that the public does not have. Conveying this information to the public better aligns private and central bank expectations about policy and the economy. And this appears to be working in practice: financial markets have become much better at forecasting the future path of monetary policy than they were up to the late 1980s, and are more certain of their forecast ex ante, as measured by implied volatilities from options contracts. Enhanced transparency is particularly valuable when policy has to deviate from its normal, systematic approach.

And even quoting Mae West,

My personal view is that the steps that we have already taken toward greater transparency have been a good thing, and that we should think seriously about venturing further along this path. As Mae West famously said, “Too much of a good thing can be wonderful.” More seriously, although it is possible to carry transparency too far—I would not, for example, want live television coverage of FOMC meetings—I support the idea of a quantitative objective for price stability. I believe that it enhances both Fed transparency and accountability and that it offers important benefits, as I have discussed. In particular, it could help to anchor the public’s long-term inflation expectations from being pushed too far up or down, and thus help avoid both destabilizing inflation scares and deflations; a credible inflation objective could thereby enhance the flexibility of monetary policy to respond to the real effects of adverse shocks.

I agree with Janet Yellen of 2006, although I would not depend as much on anchoring in the light of a recent New Zealand study. Even without the study, basing policies on something as hard-to-measure an effect as anchoring, whose strength may be dependent on events, is likely to prove to be quicksand where you once thought was firm ground.

Warren Buffett said, “It takes 20 years to build a reputation and 5 minutes to ruin it. If you think about that, you’ll do things differently”. Same goes with credibility, I say.