Question

Why is the credibility of the Fed’s policy announcements particularly important ? Provide an example.

Answer 1

The credibility of the Fed's policy announcements is particularly important for the success of monetary policies pursued by the Fed. Credibility is all about what the public at large and the market expects the Fed to do in the long-run. The expectation of people must be aligned with the policy objectives of the Fed in order to make the monetary policies successful. If the expectations of the public and the monetary policies move in the opposite direction, the monetary policies will not be effective. If the Fed has credibility on the policy objectives of Fed, they will expect accordingly and the policy objectives will be met.

Let us take an example.Suppose, the Fed has no credibility and it wants to maintain a low inflation. People might think that the Fed is not credible and people might expect high inflation. Therefore, they would ask for higher wages expecting a higher inflation. Such inflation expectation of people would actually result in higher inflation in spite of Fed's monetary policies designed to reduce inflation. So, if the Fed does not have credibility, its policies would not be effective.