While recovering from COVID-19, the global economy witnessed a significant surge in inflation. Numerous central banks, including the Federal Reserve and the European Central Bank (ECB), have responded by raising the policy interest rates, signaling their commitment to preserving price stability. However, maintaining low inflation becomes more complex when central banks face issues related to their credibility. The decision to increase policy rates involves tradeoffs, particularly regarding potential output losses. These tradeoffs are even more severe for central banks with limited credibility.
In Barcelona School of Economics Working Paper Nº 1401, “Optimal Disinflation with Delegation and Limited Credibility,” Mridula Duggal and Luis E. Rojas develop a theoretical framework on the success of Chile and Colombia during their battle against high inflation in the 1990s. Their research provides valuable insights into how central banks with limited credibility and independent monetary policy can manage the tradeoff between low inflation and associated output losses.
Establishing central banks after high inflation, Chile and Colombia faced credibility issues
Chile and Colombia experienced prolonged periods of high and volatile inflation. In the early 1990s, significant constitutional reforms were introduced, establishing more independent central banks. These reforms allowed the boards of the central banks to have longer terms than the political cycles. Furthermore, they were entrusted with the authority to make monetary policy decisions free from political influence.
Given the long history of high inflation, public trust in the central banks was low. When the central banks announced their inflation targets, skepticism regarding their independence from the government arose alongside the doubts about whether the newly established central banks could achieve their targets. This meant that agents would need to learn from the central bank decisions and realised inflation about the credibility of the new institutional arrangement.
The journey towards achieving stable inflation involved using one crucial communication tools: the one-year inflation targets. As illustrated in Figure 1 and Figure 2, inflation rates swiftly declined from double to single digits within a few years (prior to the formal adoption of Inflation Targeting) and remained relatively low on average. This remarkable progress suggests that both central banks successfully met their objectives, raising the question of how these central banks, initially facing credibility issues, managed to reduce inflation after a turbulent period.
Figure 1: Path of Inflation in Chile
Figure 2: Path of Inflation in Colombia
Intermediate targets are crucial for central banks with limited credibility, as they dynamically shape public inflation expectations.
The authors posit that intermediate targets provided the central bank with a quicker path to establishing credibility while incurring lower costs in terms of economic output. They present a theoretical framework in which a government entrusts monetary policy to an autonomous central bank whose objectives are initially determined by the government but are independent of the government’s objectives. This delegation is motivated by the desire to prevent the government from stimulating economic activity through an expansionary monetary policy, a move that, in equilibrium, is expected by the public and consequently leads to higher inflation without any accompanying increase in output – a phenomenon often referred to as the “inflation bias.” Crucially, their model acknowledges that the public does not fully believe in the credibility of this delegation arrangement, suspecting that the reform announcement may be mere rhetoric and that the central bank is not genuinely independent. This notion of limited credibility is a novel concept within this literature. The paper thus also develops on two ideas of independence, objective and instrument independence deviating from the literature of time inconsistency.
In the model, if inflation falls below people’s expectations, it incurs a cost to economic activity. On the other hand, it enhances the credibility of the central bank’s commitment to reducing inflation. This highlights that building credibility comes at a cost. By introducing intermediate inflation targets that are publicly disclosed, the authors demonstrate that the credibility-building process can be expedited, as it enables a more transparent communication of the central bank’s goals during the disinflationary phase.
The model is employed to address a crucial question: what should be the speed of the disinflation process? A more rapid disinflation process exacts an output cost, but it yields benefits in the form of reduced inflation. The optimal pace for implementing disinflation, with the use of intermediate targets, strikes a balance between the costs to inflation and output. As depicted in Figure 3, a very swift disinflation process (characterized by low persistence of the inflation targets) results in output costs outweighing the gains in inflation, making it suboptimal.
One key insight that emerges from limited credibility is that the speed of disinflation hinges on how the reform is perceived and the extent of the central bank’s control over inflation. If the public doubts the true independence of the central bank, the disinflation process must proceed more gradually to establish credibility early and avert substantial output costs. Similarly, if the central bank has limited influence over inflation (in an economy exposed to significant supply shocks), the disinflation process should be more gradual, as credibility accumulates more slowly in such a turbulent environment.
Figure 3: Output and Inflation costs by varying the speed of disinflation
For central banks with complete credibility, announcing intermediate targets might seem redundant because the public can absorb all the information about the long-term target and have complete confidence in the central banks. However, intermediate targets serve as valuable tools for central banks grappling with credibility challenges.