Is Promising Hard?

One way for monetary policy to be effective at the lower bound is to make a promise about the future. You say that not only will short-term interest rates be held low until full employment returns, but a bit beyond that to the point where you get a little price level overshooting. One issue with this, per Paul Krugman, is that a central banker attempting to implement such a strategy may face a credibility problem. In Krugman’s memorable phrase, you have to credibly promise to be irresponsible in the future.

This is a funny line and a sound underlying model, but as I’ve said before I don’t think it’s worth worrying too much about it practice. The fact of the matter is that these credible commitment problems arise all the time in life, and resolving them is pretty routine.

Consider a boss overseeing a team working on a project that’s about 5-6 weeks away from conclusion. Unfortunately, the client really wants it done by Thanksgiving. The boss says to his team, “guys if we can buckle down and get this done by Thanksgiving then we can all take the whole week between Christmas and New Year’s off.” On its face, there’s a problem here. By December if the project is already complete, the boss has no incentive to deliver on his promise of extra vacation time. And such things do happen. People lie. Workers get screwed. Such is life.

But at the same time, making promises about the future is pretty routine. Part of navigating through life competently is avoiding a reputation for being a deranged sociopathic liar, and most of us seem to manage to pull it off.

And the Fed is in some ways in a more enviable position. To summon the inflation expectations imp, it’s not necessary to persuade everyone that the Fed’s promised price level trajectory will come to pass. It simply has to be the case that on the whole people revise their expectations about the likely future path of the price level upwards. If Bernanke makes a promise about the future, some people will believe him to some extent and nobody’s going to revise their expectations downward to offset that. So the strategy should work. What’s true is that if the central bank plays the expectations targeting card once and then breaks the promise, they’ll have a very hard time playing it a second time. But that’s an excellent reason to not break the promise, and that itself is part of what makes the promise credible.