Central Bank Credibility and its Effect on Interest Rate with an Emphasis on Fiscal and Institutional Factors

Kamal, Elham; Taghinezhadomran, Vahid

doi:10.22054/ijer.2023.66803.1080

Document Type : Research Paper

Authors

¹ Ph.D. in Economics, University of Mazandaran, Babolsar, Iran

² Associate Professor, Economics, University of Mazandaran, Babolsar, Iran

https://doi.org/10.22054/ijer.2023.66803.1080

Abstract

This paper studies the effect of central bank credibility (CBC) on interest rate from the perspective of fiscal and institutional factors, using a credibility loss index. As some central banks are not successful in channeling the actual inflation towards the announced targets, it seems necessary to investigate the impact of central bank credibility on the economic variables and also analyze the fiscal and institutional determinants of central bank credibility. Therefore, using a backward-looking indicator that measures the central bank's performance as the basis for obtaining credibility, this study analyzes the impact of CBC on the interest rate, assuming credibility is endogenous for 17 developing countries during the period 1996-2019. The result indicates that increasing the level of credibility loss positively affects the level of interest rate. In other words, increasing the central bank's credibility or improving its performance reduces the level of interest rate. Since performance is a function of external fiscal and institutional factors, improving the quality of democracy in society and legal implementation of fiscal rules along with the formal adoption of inflation targeting framework not only limits the behavior of governments and establishes financial discipline, but also improves the central bank performance. This will convince economic agents that governments and central banks are committed to their promises.
1. Introduction
What determines the CBC? How CBC affects the interest rate? To address these questions, we use the backward looking measure of Neuenkirch and Tillmann (2014) which focuses on how the private sector pays attention to the past performance of the central bank when forming expectations. This measure, a credibility loss index, is defined as a gap between the average of past inflation and target inflation. This suggests that the higher the deviation from the target, the higher the credibility loss. To clarify the main drivers of the CBC, Levieuge et al. (2018) argue that there are fiscal and institutional factors, which ultimately affect the level of public’s expectations and attitude in the central bank’s ability to meet its commitment. Besides, Taghinezhadomran and Kamal (2021) investigate that central banks in the developing countries have not performed properly in the convergence of actual inflation towards the target range which could have ramifications on the macroeconomic levels and monetary variables such as interest rates. Accordingly, this paper studies the impact of credibility loss on the interest rate given the endogeneity of CBC for 17 developing countries from 1996 to 2019, using instrumental variables method. The results show that the higher the credibility loss the higher the interest rate. Additionally, establishment of budget-balance rule, the increasing the level of central bank independence and the number of veto players, and also the decreasing the level of central bank holdings of public debt are the main fiscal and institutional drivers of CBC.

2. Method and Material
Following Neuenkirch and Tillmann (2014), we assume that the higher the credibility loss (inappropriate performance of the central bank) the higher the interest rate (Eq. 2).

(1)

(2)

Where stands for the central bank independence index (the turnover rate). The turnover rate is counted by the number of central bank governor changes and denotes the number of veto players. Veto players are defined as individual and collective actors (individual politicians, political parties, and institutions), having the power to block a proposed change in current policies. Besides, their agreement is necessary before policies can be changed. sets the balance-budget rule. is central banks holdings of government debt. represents the nominal interest rate. and are the inflation gap and the credibility loss index, respectively. is the error term (iid). In this paper, we choose the fiscal and institutional variables as instrumental variables. The rationale behind that refers to the higher correlation between the fiscal and institutional variables and the credibility loss index and the lower correlation of fiscal and institutional variables with the dependent variable (interest rate). Since the endogeneity problem occurs when the independent variable is correlated with the error term in a regression model, we use the method of instrumental variables (2SLS) to examine the effect of credibility loss on the interest rate while determining the main influential fiscal and institutional factors.
3. Result and Discussion
The results in the first stage show that all of the explanatory variables significantly affect the credibility loss index. Specifically, the higher the turnover rate the higher the loss in CBC. In other words, an increase in the turnover rate of the central banker have a negative effect on the performance of the monetary institution and shows the inability of the central bank to fulfill his/her promises. Our result shows that the increased number of veto players negatively affects the credibility loss. This suggests that the more veto players, the more difficult the overturn of central bank independence. The rise of the number of checks and balances could be as a good news to stimulate agents’ expectations as the change of decision to delegate becomes harder, giving to the private sector a greater scope to reduce the expected inflation. The negative effect of rule-based budget on the credibility loss indicates that rules constrain the behavior of governments and convince the public and markets that sovereigns and central banks are committed to the announced targets. The coefficient of sovereign debt holder is also statistically significant and positive. The results in the second stage show that inflation gap and credibility loss will increase the level of interest rate. This means that the higher the deviation from the inflation target the weaker the performance of central bank. In this case, the central bank is forced to increase the interest rate to response to this deviation.
4. Conclusion
Using instrumental variables method and in two stages, this paper examined the effect of credibility loss on the interest rate while taking the endogeneity of CBC into account for 17 developing countries from 1996 to 2019. The positive impact of credibility loss on the interest rate suggests that the higher the deviation of the average of past inflation from the target, the higher loss in CBC today. This weak performance, will force the central bank to set a higher interest rate. The main reason behind that refers to the external factors such as fiscal and institutional factors, as our results suggest. In particular, the performance of the central bank is an outcome of fiscal and institutional factors, affecting the extent of interest rate. These findings indicate that simply adaption of inflation targeting framework does not improve the performance of the central bank. Rather, the legal implementation of fiscal rules, the lower fiscal dominance, and also the number of veto players could stabilize expectations and convince the public that governments and central banks are committed to their promises.

Keywords

20.1001.1.17260728.1402.28.94.3.6

Main Subjects

Monetary economy

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Central Bank Credibility and its Effect on Interest Rate with an Emphasis on Fiscal and Institutional Factors

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Volume 28, Issue 94 - Serial Number 94April 2023Pages 81-126

Volume 28, Issue 94 - Serial Number 94
April 2023
Pages 81-126