Loss of Central-Bank Credibility
When a central bank loses credibility, inflation expectations un-anchor and start chasing actual inflation, so the same shocks produce bigger, longer-lasting inflation and disinflation becomes far more costly, the difference between the 1970s and the 1980s.
| Effect | Expectations un-anchor |
|---|---|
| 1970s | Low credibility, persistent inflation |
| 1980s | Credibility rebuilt, cheaper control |
Credibility is invisible until it is gone. This scenario isolates what happens when the public stops trusting that the central bank will keep inflation near target.
With expectations un-anchored, people set wages and prices based on the inflation they are living through, not the target. A shock that would have faded in a credible regime instead lingers and compounds. The cost of disinflation, the unemployment needed to wring inflation back out, rises sharply.
History runs the experiment for us. In the 1970s, low credibility made inflation stubborn and expensive to control. After the Volcker disinflation rebuilt trust, the same kinds of shocks caused smaller, shorter inflation, underpinning decades of stability. The lesson: credibility is an asset that is cheap to spend and expensive to rebuild.
Sources: Goodfriend & King (2005). See the methodology.