Missing Import Price Changes and Low Exchange Rate Pass-through

A large body of empirical work has found that exchange rate movements have only modest e¤ects on ination. However, the response of an import price index to exchange rate movements may be underestimated because some import price changes are missed when constructing the index. We investigate downward biases that arise when items experiencing a price change are especially likely to exit or to enter the index. We show that, in theoretical pricing models, entry and exit have di¤erent implications for the timing and size of these biases. Using Bureau of Labor Statistics (BLS) microdata, we derive empirical bounds on the magnitude of these biases and construct alternative price indexes that are less subject to selection e¤ects. Our analysis suggests that the biases induced by selective exits and entries are modest over typical forecast horizons. As such, the empirical evidence continues to support the conclusion that exchange rate pass-through to U.S. import prices is low. JEL Codes: F31, F41, E30, E01, C81 Keywords: exchange rate pass-through, import prices, item replacement This research was conducted with restricted access to Bureau of Labor Statistics (BLS) data. The views in this paper are solely the responsibility of the authors and should not be interpreted as reecting the views of the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, or any other person associated with the Federal Reserve System or the BLS. We thank Carolyn Evans, Hakan Yilmazkuday, Nicholas Li, Emi Nakamura, Jón Steinsson, John Rogers, Kei-Mu Yi, and seminar participants at the Federal Reserve Board, Federal Reserve Bank of New York, Bank of Canada, Banque de France, George Washington University, BLS Price and Index Number Research group, and conference on Microeconomic Sources of Real Exchange Rate Behavior at Vanderbilt University. Kelsey Ayres, Benjamin Hopkins, Gregory Howard, and Robert Sockin provided superb research assistance. yE. Gagnon and R. Vigfusson are at the Federal Reserve Board. B. Mandel is at the Federal Reserve Bank of New York. Comments and suggestions can be directed to etienne.gagnon@frb.gov, benjamin.mandel@ny.frb. org, robert.j.vigfusson@frb.gov. In conducting monetary policy, central bankers are interested in how much exchange rate movements a¤ect the prices of imported goods (exchange rate pass-through) as uctuations in these prices can, in turn, a¤ect domestic prices and output. Commonly, exchange rate pass-through is measured by regressing changes in published import price indexes on changes in trade-weighted exchange rate indexes along with other explanatory variables. Using these regressions, researchers have estimated low rates of exchange rate pass-through for the United States. Recent estimates (for example, Campa and Goldberg [2005], and Marazzi and Sheets [2007]) suggest that, following a 10 percent depreciation of the dollar, U.S. import prices increase about 1 percentage point in the contemporaneous quarter and an additional 2 percentage points over the next year, with little if any subsequent increases. These low estimates have led several authors to formulate theories which generate incomplete pass-through.1 In a recent paper, Nakamura and Steinsson (2012) argue that actual long-run passthrough is substantially higher than these standard estimates because published price indexes are missing price changes associated with item replacement. In their words, "[if ] the prices of new products entering the index have already adjusted to exchange rate movements . [then] the response of these prices to movements in exchange rates . will be lost in transit(i.e., neither picked up by an observed price change of the exiting nor entering product). " They derive an adjustment factor for standard long-run pass-through estimates under speci c assumptions regarding the nature of item substitutions and the way rms set prices. They conclude that measured pass-through is substantially underestimated, implying that exchange rate pass-through to U.S. import prices is much more complete in the long run than was previously thought. Our paper reassesses this conclusion by developing a general framework for understanding how sample turnover in conjunction with pricing assumptions impacts measured passthrough, and by proposing and implementing new ways of gauging the biases in standard estimates. Throughout our discussion, we emphasize the implications of sample exits and sample entries over the rst couple years following an exchange rate shock, as such a shortterm horizon is most commonly employed by policymakers and is especially useful for discriminating among theoretical models. Our conceptual framework captures the possibility that an item whose price is about to change is more likely than others to leave the index (resulting in a selective exit) and that an item whose price recently changed is more likely than others to be added the sample (resulting in a selective entry). In either cases, items tend to release their price pressure outside of the period spent in the sample, thus lowering 1These papers include Atkeson and Burstein (2008), Gopinath, Itskhoki, and Rigobon (2010), Gopinath and Itskhoki (2010), and Gust, Leduc, and Vigfusson (2010).