Exchange rate pass-through into euro area inflation
Exchange rate movements are one factor affecting inflation in the euro area.
The exchange rate can influence euro area inflation both directly via the price of imported final consumer goods, and indirectly via the price of imported intermediate goods used in euro area domestic production. Empirical studies have shown that exchange rates have a stronger and more immediate effect on import prices than on final consumer prices. Moreover, the size and speed of the exchange rate effects differ across product categories. The macroeconomic environment, factors affecting pricing decisions at the firm level and the shocks driving the exchange rate movements determine the strength of the exchange rate effects on inflation. Over time, the size of exchange rate pass-through is documented to have declined in the euro area and other advanced economies. This decline can be attributed to several factors, including the low inflation environment prevailing in many economies over the past two decades and the changing composition of imports.
Introduction
The degree to which exchange rate changes are transmitted to import prices and subsequently to final consumer prices is commonly referred to as the “exchange rate pass-through”. Understanding the role of exchange rates in shaping economic outcomes is important from a monetary policy perspective. In particular, assessing the degree of pass-through of exchange rate movements to import or domestic prices is essential for monitoring and forecasting domestic inflation.
Exchange rate changes are transmitted to HICP inflation via a number of channels, both direct and indirect. Exchange rate movements are passed on directly to consumer prices via their impact on the import prices of final consumer goods. Following an exchange rate depreciation, imported final consumer goods become more expensive (“first stage pass-through”), pushing up overall HICP inflation. Figure 1 provides an overview of the direct and indirect effects of a depreciation in the euro nominal effective exchange rate (NEER). The direct channel is depicted by the arrow labelled “1”, which joins import prices directly with consumer prices and depends on the pricing decisions of foreign producers exporting to the euro area.
Indirect effects, which can take longer to trickle through the economy, work via production costs and real channels. The euro depreciation translates into higher production costs due to more expensive imported inputs, and these feed through the different stages of domestic intermediate and final goods production (“second stage pass-through”), with an inflationary impact on domestic consumer prices. This channel is depicted by the arrows labelled “2”, which connect import prices with producer prices and then consumer prices, and depends, inter alia, on the pricing behaviour of domestic firms. The latter might pass on the increase in costs resulting from the euro depreciation in order to keep mark-ups and profits constant, or they might keep prices constant and accept lower profits, thus dampening the passthrough to final consumer prices.
As regards the real channels, the euro depreciation decreases euro area export prices denominated in foreign currency and increases import prices in euro. This, in turn, leads to an increase in net exports and higher GDP growth (indicated by the arrows labelled “3”). As the increase in real GDP growth leads to higher labour demand and higher wages, this puts upward pressure on consumer prices (indicated by the arrows labelled “4”). These indirect effects can be reinforced by expectations of a positive loop of future higher growth and inflation.
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