Inflation and Exchange Rate Pass-Through
One sentence summary: Monetary policy shocks are responsible for higher exchange rate pass-through which can be reduced by more flexible exchange rate regimes or a credible commitment to an inflation target.
The corresponding paper by Jongrim Ha, Marc Stocker and Hakan Yilmazkuday is accepted for publication at Journal of International Money and Finance.
The World Bank working paper version is here.
Abstract
The degree to which domestic prices adjust to exchange rate movements is key to understanding inflation dynamics, and hence to guiding monetary policy. However, the exchange rate pass-through to inflation varies considerably across countries and over time. By estimating structural factor-augmented vector-autoregressive models for 55 countries, this paper brings to light two fundamental factors accounting for these variations: the nature of the shock triggering currency movements and country-specific characteristics. Regarding the former, monetary policy shocks are associated with higher exchange rate pass-through measures compared to other domestic shocks, while global shocks have widely different effects across countries. Regarding the latter, pass-through ratios tend to be lower in countries that combine flexible exchange rate regimes and credible inflation targets, where central bank independence can greatly facilitate the task of stabilizing inflation following large currency movements and allows fuller use of the exchange rate as a buffer against external shocks.
Non-technical Summary
Monetary authorities respond to currency movements to the extent that they impact consumer prices and thus inflation. This response not only requires information on the source of currency movements but also the persistence of the impact on inflation. Country characteristics may also play important roles within this picture, because, for example, the risk of policy missteps is particularly elevated in emerging market and developing economies (EMDEs), where large currency movements are more frequent and central banks have a greater propensity to respond to them. This highlights the importance of correctly assessing the exchange rate pass-through ratio (ERPTR), defined in this paper as the percentage increase in consumer prices associated with a 1 percent depreciation of the effective exchange rate following a specific shock after one year.
A rich literature has demonstrated that currency movements are only partially transmitted to domestic prices, with effects dissipating through the production chain. The pass-through to consumer prices goes through various channels, from direct effects through energy and other commodity prices, to indirect effects through import prices, wage formation, and profit markups. Even in the case of internationally traded goods, different forms of market segmentation and/or nominal rigidities may explain incomplete pass-through.
Many structural factors have been associated with a lower sensitivity of domestic prices to exchange rate movements, including the degree of competition among importing and exporting firms, the frequency of price adjustments, the composition of trade, the level of participation in global value chains, the share of trade invoiced in foreign currencies, and the use of currency hedging instruments. A credible monetary policy framework that supports well-anchored inflation expectations has also been viewed as an effective way to reduce the pass-through to consumer prices.
Beyond structural factors and country characteristics discussed so far, the nature of the macroeconomic shock that triggers an exchange rate movement also plays a key role in determining the size of the associated pass-through. This reflects the fact that shocks impacting the exchange rate concurrently affect activity, markups, productivity, and several other factors that influence price formation and inflation expectations. It is thus likely that the extent of estimated ERPTRs will vary widely depending on the shock that triggers them---a possibility that most empirical studies have not considered. For instance, if the ERPTR associated with monetary policy changes is higher than the one associated with other types of shocks, there is a risk that a central bank might underestimate the exchange rate channel of its actions and maintain an excessively tight (or loose) monetary policy stance relative to what is needed to stabilize inflation and output. This may lead to unnecessary fluctuations in activity and make the anchoring of inflation expectations more difficult to achieve over time.
Against this background, this paper contributes to a recent strand of the literature that emphasizes the importance of identifying underlying shocks to assess the transmission of exchange rate movements to inflation and, therefore, to formulate the correct monetary policy response. Three questions are asked. First, how have exchange rate movements impacted inflation over time? Second, how does the pass-through to inflation depend on the underlying shock triggering the exchange rate movement? Third, what country characteristics are associated with lower pass-throughs?
To answer these questions, this paper starts with examining the extent of the co-movement between inflation and exchange rates across 34 advanced economies and 138 EMDEs, including event studies of significant depreciation and appreciation episodes. It is shown that large depreciation episodes are associated, on average, with more significant increases in consumer price inflation in EMDEs than in advanced economies. Unconditional pass-throughs tend to increase with the size of the depreciation in both country groups. There is also evidence for broad-based decline in pass-through among EMDEs over time. Nevertheless, when the correlations between inflation and nominal effective exchange rate changes are considered, there is heterogeneity both across countries and over time, suggesting that different shocks as well as country-specific characteristics can shape the response of inflation to currency movements. The identification of these shocks, however, requires a formal investigation as we detail next.
The formal investigation is achieved by using a series of factor-augmented vector autoregression (FAVAR) models, where both global and domestic variables are used to identify the corresponding shocks. This is achieved by initially constructing the global series of inflation and output growth, where dynamic factor models are used. The constructed global series are combined with global oil price growth as well as domestic series of inflation, output growth, interest rate and nominal effective exchange rates in FAVAR estimations at the country level. Due to data availability, estimations are achieved for 55 countries, including 26 EMDEs. Shock-specific ERPTRs are estimated as the ratio between the one-year cumulative impulse response of consumer price inflation and the one-year cumulative impulse response of the exchange rate change, both following a specific shock.
The estimation results show that monetary policy shocks are associated with a higher exchange rate pass-through compared to other domestic shocks, while global shocks have widely different effects across countries. When a weighted average of shock-specific pass-through is computed for each country to facilitate comparison with the literature, EMDEs have a median (across countries) ERPTR of about 0.15 starting from 1970s, while this number has dropped to 0.08 after 1998. Although a similar drop is also observed for advanced countries over time, the corresponding ERPTRs are much lower, suggesting that EMDEs are the ones that have experienced significant pass-throughs.
Since country-specific ERPTRs are highly heterogenous, we further connect the empirical results to country-specific characteristics by paying particular attention to monetary policy frameworks, participation in GVCs, and foreign-currency invoicing. It is shown that pass-throughs are generally lower in countries with more flexible exchange rate regimes and a credible commitment to an inflation target. This, in turn, facilitates the central bank's task of stabilizing inflation and makes exchange rate movements a more effective buffer against external shocks. In contrast, domestic demand shocks are typically associated with negative and mostly insignificant pass-through ratios, due to the offsetting effects of growth and exchange rate channels (for example, weakening domestic demand giving rise to currency depreciation and declining inflation).