Central bank credibility and its effect on stabilization

This paper analyzes central bank credibility and its stabilizing effects for a set of emerging economies (EEs) and advanced economies (AEs). First, we analyze historical performance and the impact of inflation targeting on performance for nineteen countries and test whether this performance shows an interest rate stabilizing effect. To do this, we compute backward-looking credibility indicators whereby the performance metric is better when observed inflation is closer to the central bank’s explicit or implicit inflation target range. Second, we analyze whether inflation expectations have been anchored using a forward-looking asymmetric credibility indicator and whether this has a stabilization effect on reducing interest rate volatility and macroeconomic volatility in nine economies. The results show that inflation targeting improves performance significantly in nineteen countries. The findings support the hypothesis that credibility has an interest rate stabilization effect for EEs and AEs. Also, we found significant concurrent macroeconomic stabilization effects. The panel regression results show that forward-looking asymmetric credibility has a significant and negative impact on interest rate volatility, inflation volatility, output volatility, and macroeconomic volatility in both EEs and AEs. The results are robust to two different volatility measures. The findings have important policy implications: greater central bank credibility yields stabilizing effects.