EXCHANGE RATE AND INFLATION : A CASE OF SULKINESS OF VOLATILITY

There is a paucity of methodologically sound studies directly addressing exchange rate and inflation volatilities, and the existing ones suggest a relation between these variables, although there is no consensus about its characteristics. Therefore, it is necessary to verify the effects of exchange rate volatility, especially under an inflation-targeting regime where the monetary authority must know, as precisely as possible, the factors that affect price behavior. This paper seeks to establish the relation between exchange rate and inflation volatilities by adopting a more sophisticated econometric methodology than those applied so far a bivariate GARCH model, dealing directly with the effects of conditional volatilities, which has been largely unexplored by the literature. We find a semi-concave relation between exchange rate and inflation variances, differently from what was estimated for financial series and in line with the intuition obtained from other studies. The article innovates by (i) trying to establish a relation between exchange rate and inflation volatilities and its implication for the monetary policy, (ii) applying a multivariate GARCH model, using conditional variances to analyze the relation between those volatilities and (iii) showing that traditional tests performed with exogenously constructed volatility series are sensitive to the criteria chosen to construct such series and do not reveal relevant features of that relation. Key-words: exchange rate, inflation, volatility, GARCH models JEL Classification: E31; F41. I – INTRODUCTION Although the literature about the impact of exchange-rate volatility is not as extensive as the one available on exchange-rate pass-through, some authors highlight such relation. Whether the impacts are significant or not remains controversial. However, CAPORALE and PITTIS (1995), point out that “Economic theory concerned with behavior under uncertainty suggests that agents ́ decisions are based upon the conditional distribution of the relevant random variables. In the presence of risk aversion, not only the conditional mean but also the higher moments, in particular the conditional variance, will play a role. (p. 397)” The study of the effects of exchange rate volatility on inflation becomes important since we must verify whether that volatility should be a worry for the Central Bank’s actions when monetary 1 Economist, Research Department of the Central Bank of Brazil, and PhD student at Universidade Federal do Rio Grande do Sul (UFRGS). E-mail: christiane.albuquerque@bcb.gov. br 2 Professor of Economics, Universidade Federal do Rio Grande do Sul (UFRGS), and associate researcher of CNPq. Email: msp@ufrgs.br ∗ The authors would like to thank Angelo Marsiglia Fasolo and Sergio Afonso Lago Alves, both from the Research Department of the Central Bank of Brazil, for their comments on a previous version of this paper. The remaining errors are the authors’ responsibility. The views expressed in this work are those of the authors and do not necessarily reflect those of the Central Bank of Brazil or its members. policy decisions are at stake. This is so because higher inflation volatility means higher uncertainty, affecting inflation expectations, a crucial variable in decisions under an inflation-targeting regime. It is possible to classify the literature in two groups: those authors to whom there is no connection between exchange rate and macroeconomic variables volatilities and those who states the opposite. According to the first group, exchange rate volatility is not important to macroeconomic variables, since empirical evidence shows a substantial increase in it during floating exchange rate regimes, while macroeconomic variables do not present a similar rise in their volatilities. The second group establishes that relation focusing on different variables, mainly in the effects over trade. Concerning prices, analysis are made under different frameworks, the most common of them being exposed further on this introduction. Concerning the first group of authors, we highlight the works of KRUGMAN (1988), BAXTER and STOCKMAN (1988), FLOOD and ROSE (1995), OBSTFELD and ROGOFF (2000), ROGOFF (2001) and DUARTE and STOCKMAN (2002). KRUGMAN (1988) justifies the disconnection of exchange rate fluctuations from real fluctuations by a circular logic: since the exchange rate is volatile, it disconnects from fundamentals and, by being disconnected, exchange rates may be more volatile. The first is caused by the lack of reactions of firms to an increased volatility, both for seeing it as temporary and for the pricing-tomarket, which prevents firms from altering their prices in countries to which they export their products as much as expected. On the other hand, by being disconnected, exchange rates may be more volatile because, if exchange rate fluctuations were immediately followed by changes in product allocation, changes in the trade account would be such that they would lead to exchange rate devaluation. If this devaluation were immediately passed through to prices, the resulting high inflation differentials (and, therefore, differentials in real interest rates) would bring the exchange rate back to levels that are “closer to reality” and, hence, volatility would be reduced. BAXTER and STOCKMAN (1988) develop a study with a 49-country sample in the post-war period (1960 to 1985) under different exchange rate regimes and conclude that some series of real exchange rate, trade and industrial production became more volatile after the Bretton Woods period. However, evidence would not attribute the changes to the exchange rate regime, but to exchange rate itself. To FLOOD and ROSE (1995), who carried out a monthly study on nine industrialized countries from 1960 to 1991, if the volatilities of macroeconomic variables do not change with the exchange rate regime, it is because there is not a clear trade-off between the reduction in exchange rate volatility and macroeconomic stability. When it comes to inflation, the authors do not find a trade-off between its level or volatility and exchange rate volatility. The results would be corroborated by a sticky price model, in which price variations are a function of the output gap, expected inflation and the output is a function of exchange rates, domestic and external prices and of the ex-ante real interest rates. OBSTFELD and ROGOFF (2000) attribute the exchange rate disconnect puzzle (high volatility of exchange rate disconnected, apparently, from fundamentals) to a mix of trade costs, monopoly and pricing-to-market in the domestic market. The tradables markets are very segmented, having effects on the exchange rate in such a way that they control its variation, even though nontradables push it up. With pricing-to-market at retail level, consumers will be insulated from exchange rate effects until these have been incorporated by wholesale import prices and, only afterwards, passed through to consumers in a period longer than that suggested by the half-life of PPP. Price rigidity also contributes to that disconnection: with rigid prices and macroeconomic variables (e.g. consumption) insulated from exchange rates in the short run, the exchange rate adjustment has a minimal effect and, therefore, it has to be high to allow for the clearing in financial markets. Real effects would be, therefore, too delayed to be captured by econometric tests. As incomplete passthrough in the short run is also pointed out by DEVEREUX and ENGEL (2002), the exchange rate volatility is much higher than that resulting from shocks to other variables. ROGOFF (2001) points out that, in the macroeconomic chaos of the 1970s, there was a perspective that the calmness in exchange rate markets would follow inflation stabilization since, even in the weak version of PPP, price instability is incompatible with exchange rate stability. The belief was strengthened by Dornbusch’s overshooting model, where exchange rate has a disproportionate adjustment to monetary shocks in the short run. Therefore, monetary instability would lead to even higher exchange rate instability. However, the evidence in the following decades showed that the latter is, at most, part of the former, since the volatilities of the world’s main currencies remained at high levels. This volatility has costs over exports and imports, in addition to hedging costs. However, one should not analyze the effects of volatility by looking at the exchange rate regime – since volatility is always higher under floating exchange rates – but rather ask if that volatility makes product, investment and consumption more volatile. Nonetheless, the author points out that the empirical issue is not solved, as the differences in effects may be due to microeconomic distortion of the models. Although exchange rate volatility is a disturbance, the author does not consider it strong enough to be an economic policy target. DUARTE and STOCKMAN (2002) credit this fact to the presence of noise traders, so that the same variability in exchange rate does not affect real variables. As for the authors who find some relation between exchange rate and macroeconomic variables volatilities, we highlighted those whose works deal, in some sense, with inflation volatility or whose conclusions may be related to it. Concerning specifically the impacts of exchange rate volatility on prices, the available literature is even scantier, with most articles focusing on the volatility of relative prices across countries (basically, developed countries) or pursuing different aims (for instance, investment decisions), in which the result concerning inflation is a by-product. 3 According to the authors, the Purchase Power Parity Puzzle – that is, the non-validity of PPP in the short run – may be considered as a special case of the Exchange Rate Disconnect Puzzle. Few studies refer to the effects of exchange rate volatility on domestic price inflation, eithe