Frederic S Mishkin: Exchange rate pass-through and monetary policy
Speech by Mr Frederic S Mishkin, Member of the Board of Governors of the US Federal
Reserve System, at the Norges Bank (Central Bank of Norway) Conference on Monetary
Policy "Jarle Bergo Colloquium: Globalisation and Monetary Policy", Oslo, 7 March 2008.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
Since 2002, the U.S. dollar has depreciated over 40 percent against a basket of major
currencies, weighted by their countries' trade with the United States. Over the past two years,
the trade-weighted dollar has fallen by 15 percent. The decline in the value of the U.S. dollar,
particularly if it continues, has raised concerns that it might lead to higher inflation. After all, a
lower value of the dollar is likely to raise the cost of imports, which can feed into higher
consumer prices.
But how much of a risk to inflation is posed by a depreciation of the domestic currency? This
depends on how much of the falling value of the currency is passed through to import prices
and then on to overall consumer prices. In my remarks today, I will discuss what recent
economic research tells us about exchange rate pass-through and what this suggests for the
control of inflation and monetary policy. I will first focus on exchange rate pass-through from
a macroeconomic perspective and then examine the microeconomic evidence. In light of this
evidence, I will then discuss the implications of exchange rate movements on the conduct of
monetary policy.1
Traditional monetary explanations of currency depreciation
There is a long history behind the belief, often expressed in the popular press, that nominal
exchange rate depreciation is closely linked to price inflation. Even prior to the U.S.
Constitutional Convention of 1787, policymakers recognized that monetary systems without a
nominal anchor - that is, systems which relied on paper money not backed by gold or other
commodities - were prone to large currency devaluations and high inflation. The lack of a
nominal anchor is one of the reasons the U.S. Constitution restricted the states from issuing
their own currencies (Michener and Wright, 2005).
Traditional monetary theory regards excessive money creation as a common source of
instability in both the exchange rate and price level. In the presence of large monetary
shocks, price inflation and exchange rate depreciation should, therefore, be closely linked.
The large exchange rate depreciation and coincident inflation that occurred following many
episodes of wartime suspension of the gold standard - including those in Britain during the
Napoleonic Wars and after World War I - were often cited in support of the traditional
monetary interpretation (Frenkel, 1976).
Drawing on more recent experience, countries with relatively rapid rates of currency
depreciation following the breakup of the Bretton Woods System had relatively high rates of
inflation. For example, Sweden's currency depreciated by an average of 5 percent per year
between 1973 and 1985 against the deutsche mark, and its annual inflation rate was on the
order of 4 percentage points higher than German inflation over the same period. In addition,
until the past decade, many countries in Latin America were plagued by a combination of
chronically high inflation and exchange rate depreciation. For example, the Mexican peso
depreciated by an average of 31 percent per year against the dollar between 1977 and 1995,
while the Mexican inflation rate averaged about 30 percent per year higher than the U.S.
inflation rate.
Recent macro evidence: pass-through to consumer prices
The correlation between consumer price inflation and the rate of nominal exchange rate
depreciation can indeed be high in an unstable monetary environment in which nominal
shocks fuel both high inflation and exchange rate depreciation. But a salient feature of the
data is that this correlation has been very low over the past two decades for a broad group of
countries that have pursued stable and predictable monetary policies. Moreover, the
evidence suggests that even countries in which inflation and exchange rate depreciation
appear to have been fairly closely linked historically have experienced a sizeable decline in
pass-through following the adoption of improved monetary policies.
Some of the most striking macro evidence of a weak correlation between exchange rate
depreciation and inflation comes from case studies of episodes in which even highly open
economies experienced little upward pressure on inflation following large depreciations of
their currencies (Lafleche, 1996/1997; Cunningham and Haldane, 2000; Goldfajn and
Werlang 2000; Gagnon, 2004; Burnstein, Eichenbaum, and Rebelo, 2007). For example,
after Sweden and the United Kingdom's withdrawal from the Exchange Rate Mechanism
(ERM) of the European Monetary System in September 1992, both countries experienced
low inflation: Swedish price inflation was contained to only 3 percent per year on average in
1993 and 1994 despite a cumulative nominal depreciation of the krona of 9 percent, while the
United Kingdom's inflation rate averaged only 2 percent per year in 1993 and 1994 even
though the pound fell by 15 percent.2
The case study evidence has been confirmed by time series analysis. Gagnon and Ihrig
(2004), for example, estimated pass-through to consumer prices for a broad set of industrial
countries using data over the 1971-2002 period. Over their entire sample, the authors
estimated pass-through to be roughly 0.2, indicating that a 10 percent nominal depreciation
caused the consumer price level to rise by 2 percent in the long run, with most of it occurring
quickly. However, when they split their sample using country-specific break points - typically
during the early 1980s - to control for the effect of switching to a more stable monetary policy
regime, they found a marked decline in pass-through. Specifically, they estimated
passthrough to be 0.05 for the later period in their sample of twenty countries, implying that 10
percent depreciation would cause prices to rise only 0.5 percent. McCarthy (1999) reached
similar conclusions, finding a decline in exchange rate pass-through for all nine of the
industrial countries that he examined in the period from 1983 to 1998 relative to the earlier
period from 1976 to 1982.3
Explanation of the macro results
Indeed, the correlation between consumer price inflation and exchange rate changes is now
very low in most industrial countries. So, how does one explain these results?
In a previous speech (Mishkin, 2007), I observed that many of the basic facts of the recent
behavior of inflation dynamics - less persistence of inflation, a flatter Phillips curve, less
responsiveness of inflation to shocks to energy prices and the exchange rate - can all be
explained by recognizing that, in recent years, expectations of inflation have become much
more solidly anchored. Traditional monetary theorists were correct in emphasizing that
exchange rate depreciation and inflation were likely to be closely linked under an unstable
monetary policy environment without a nominal anchor. But in the context of a stable and
predictable monetary policy environment, nominal shocks play a vastly reduced role in
driving fluctuations in consumer prices and the exchange rate, so that there is no reason a
priori to expect much association between these variables. Thus, a stable monetary policy -
supported by an institutional framework that allows the central bank to pursue a policy
independent of fiscal considerations and political pressures - effectively removes an
important potential source of high pass-through of exchange rate changes to consumer
prices.
Moreover, with expectations of inflation anchored, real shocks arising from various channels
- whether from aggregate demand, energy prices, or the foreign exchange rate - will also
have a smaller effect on expected inflation and hence on trend inflation. The presence of a
strong commitment to a nominal anchor in many countries - that is, the use of monetary
policy actions and statements to maintain low and stable inflation - helps explain why even
sizeable depreciations of the nominal exchange rate have exerted small effects on consumer
prices in many recent historical episodes and can be expected usually to exert small effects
in future episodes. John Taylor (2002) made this exact point in a well-known paper where he
argued that the establishment of a strong nominal anchor in many countries in recent years
has led to the very low pass-through of exchange rate depreciation to inflation that we find in
the data. Of course, an important corollary is that low exchange rate pass-through will persist
only so long as the monetary authorities continue to ratify the public's expectations that they
will continue to respond aggressively to shocks that have potentially persistent adverse
effects on inflation.
An important caveat to the conclusion that exchange rate pass-through to consumer price
inflation is now very low is that the empirical evidence on which it rests is mainly
unconditional in nature. In other words, it reflects the average outcome across a range of
different episodes but does not tell us how the relationship may vary depending on which
shocks hit the economy. However, certain specific shocks and the responses to them may be
associated with considerably higher pass-through than indicated by these average
relationships. For example, as I will illustrate later, a shock to desired portfolio holdings that
causes the dollar to depreciate could, in principle, push up inflation for a sustained period,
even if it had little influence on longer-term inflation expectations. Because such risks to the
inflation outlook are clearly a concern of monetary policy, a strong rationale exists for
attempting to identify the transmission channels through which specific shocks affect
inflation, real activity, and the exchange rate. To identify those channels, we must keep in
mind that the transmission from exchange rates to consumer prices depends importantly on
the economic channels that influence pass-through from exchange rates to import prices.
Accordingly, I will next review that burgeoning literature and its implications for the
transmission process.
More micro evidence on pass-through to import prices
Although the price measures upon which monetary policy makers focus the most attention
are broad measures of consumer prices, most of the vast literature examining the effects of
exchange rates on prices focuses on import prices at either an aggregate, sectoral, or
industry level.4
Turning first to studies using broad indexes of import prices, considerable evidence suggests
that pass-through to U.S. import prices is quite low and has declined markedly in recent
years. For example, one study by Marazzi and Sheets (2007) found that the average
cumulative response of the U.S. import price index to an exchange rate change declined
from around 0.5 in the 1970s and 1980s to around 0.2 in the past decade.5 The decline in
responsiveness is especially apparent in finished goods, including consumer goods, capital
goods excluding computers and semi-conductors, and automotive products (Gust, Leduc,
and Vigfusson, 2006).
Evidence also suggests that pass-through to import prices in many major U.S. trading
partners is well below unity, even if typically somewhat higher than in the United States. For
example, Campa and Goldberg (2008) reported that the estimated pass-through to import
prices for the United States ranked sixth-lowest among the twenty countries that they
examined. Pass-through to import prices also appears to have declined significantly in many
major foreign countries (Ihrig, Marazzi, and Rothenberg, 2006; Otani, Shiratsuka, and
Shirota, 2006).
The evidence from aggregate import price indexes is corroborated by industry studies that
indicate that the response of prices to changes in foreign costs - including the exchange rate
component - is quite low. For example, Goldberg and Hellerstein (2007) found that the
passthrough of changes in foreign costs to the retail price of imported beer was only 7 percent, so
that a 10 percent rise in dollar-denominated costs would push up the price of beer by only
0.7 percent.6
Explanations of the micro results
In interpreting this evidence, it is useful to begin with the observation that low pass-through to
import prices is not a prerequisite for low pass-through to consumer prices. Even if import
prices react strongly to exchange rates, a monetary policy stance that is sufficiently reactive
to inflation can insulate consumer price inflation from the effects of a shock that causes the
exchange rate to depreciate. For example, although the United Kingdom experienced a very
large increase in import prices of about 13 percent in the half-year following the ERM crisis -
which was nearly as large as the depreciation of its multilateral nominal exchange rate -
consumer price inflation remained subdued.
There are, however, at least two reasons why evidence of low pass-through to import prices
is relevant for understanding and assessing pass-through to consumer prices. First, evidence
of low pass-through to import prices provides strong corroboration of the empirical evidence
discussed earlier indicating low pass-through to consumer prices as well as of my
interpretation of the role of a strong nominal anchor in achieving the latter result. If
commitment to a nominal anchor was weak, and, as a result the economy was buffeted by
nominal shocks - due perhaps to shifts in the central bank's target for trend inflation -
passthrough to import prices should be both rapid and complete, and hence easier to identify
empirically than using broader price indexes. But the fact that exchange rate pass-through to
import prices is far below unity, and appears to have declined as countries have pursued
more stable and predictable monetary policies, provides a strong rebuttal to the argument
that exchange rate depreciation is necessarily attributable to an unstable monetary policy.
The second reason that evidence of low pass-through to import prices is important is that it
provides useful clues about the economic channels through which exchange rate changes
affect activity and prices. Notably, the empirical evidence contrasts starkly with the
implications of a large class of open economy models that either embed the assumption of
purchasing power parity or at least imply that producers have a constant desired markup
over marginal cost. The empirical shortcomings of this class of models have spawned an
enormous and innovative literature that has attempted to explain incomplete pass-through to
import prices. As I will discuss, the new models that researchers have developed in this effort
have substantially different implications for the transmission of shocks to exchange rates,
consumer prices, and real output than their predecessors, and, in particular, imply that
exchange rate changes tend to have much smaller expenditure-switching effects on real
activity. But before proceeding to that discussion, it is worth highlighting several prominent
theoretical explanations that have been offered to account for low exchange rate
passthrough.
The fact that exporters frequently appear to "price to market" provides one key explanation
for incomplete pass-through to import prices (originally proposed by Krugman, 1987; and
Dornbusch, 1987).7 In monopolistically competitive markets, optimizing firms vary their
desired markup over marginal cost across different markets depending on the elasticity of
demand that they face in each market. These demand elasticities depend on the firm's
market share, which in turn is affected by exchange rates. For example, the new version of
the SIGMA model - a dynamic stochastic general equilibrium (DSGE) model used at the
Federal Reserve Board for policy simulations - adopts a framework in which the desired
markup of producers varies directly with market share; because high-cost producers have a
low market share, they desire to set a relatively low markup. This specification implies that a
firm exporting to the United States whose currency appreciated against the dollar would want
to lower its markup to mitigate its loss in market share and is thus consistent with
less-thancomplete pass-through of exchange rate changes to import prices.8
Second, the combination of local currency pricing - meaning that an exporting firm sets the
price of its good in the currency of the country to which it exports - together with nominal
price rigidities implies that exchange rate fluctuations will have less impact on import prices,
at least in the short run (Devereux and Engel, 2002; Bacchetta and van Wincoop, 2005;
Campa and Goldberg, 2005; Gopinath, Itskhoki, and Rigobon, 2007; Gopinath and Rigobon,
forthcoming). Pricing in local currency seems to be even more prevalent for exports to the
United States, which has such a large market. This may account for why correlations
between exchange rates and import prices appear to be lower for the United States than for
most other countries.
Third, several studies have pointed out that distribution costs make up an important
component of the retail price of imported goods (Burstein, Neves, and Rebelo, 2003; Campa
and Goldberg, 2005; Berger and others, 2007). Because distribution costs are probably fairly
insensitive to shocks driving the exchange rate or foreign costs, they help insulate the retail
price of imported goods from the effects of exchange rate fluctuations.9
Finally, cross-border production can lead to lower pass-through. If production occurs in
several stages in a number of different countries, then the final good embodies costs in
various currencies that may not all move together, resulting in lower pass-through (Bodnar,
Dumas, and Marston, 2002; Hegji, 2003).
Implications for monetary policy
As I have discussed, an important limitation of the empirical evidence that indicates there is
only a small increase, on average, in consumer price inflation when the exchange rate
depreciates is that it is unconditional in nature: It does not tell how the relationship may vary
depending on which shocks hit the economy. One reason that structural models are useful is
that they allow us to assess the relationship between exchange rate depreciation and
consumer price inflation for a wide array of specific shocks, some of which may be regarded
as potential risks to the outlook for inflation and real activity. Structural models - especially
modern DSGE models - are also helpful from a heuristic standpoint insofar as they highlight
the economic channels through which shocks affect the economy, which is important in
assessing the transmission from exchange rates to inflation and real activity.
The implications of a structural model for exchange rate pass-through clearly are sensitive to
underlying features of the modeling environment. In formulating the SIGMA model, it was
regarded as crucial that the model account for the empirical regularity of low pass-through of
exchange rate changes to import prices. As I will illustrate, modeling assumptions that affect
pass-through to import prices can have a major influence on the implied link between
consumer price inflation and the exchange rate for any given shock.
Most open-economy DSGE models in the literature - including the first generation of the
Federal Reserve Board's SIGMA model described in Erceg, Guerrieri, and Gust (2006) -
have embedded Dixit-Stiglitz preferences, implying that the desired markup of price over
marginal cost is a constant. In such a framework, there is complete pass-through of
exchange rate changes to import prices, at least after short-lived nominal price rigidities wear
off. Because import prices respond one-to-one to the exchange rate after a few quarters,
shocks that cause the exchange rate to depreciate can put substantial upward pressure on
consumer prices through the imported price component as well as through stimulating real
activity by encouraging higher real net exports.
It is instructive to contrast the implications of this "full pass-through" (to import prices) setting
with the one that is embedded in the new version of SIGMA, which allows for variable
desired markups. As noted previously, this feature tends to markedly damp pass-through
from exchange rates to consumer prices in line with the empirical evidence I have discussed
- both directly, because import prices respond by less to the exchange rate, and indirectly,
because exchange rate changes tend to have smaller effects on domestic production. In the
terms of the literature, this specification forces a substantial "disconnect" between changes in
exchange rates, inflation, and real activity.10
To illustrate how features affecting pass-through to import prices affect pass-through to
consumer prices and output, let's consider some simulations of the SIGMA model, as shown
in the figure, for the case of a shock to portfolio preferences that causes the dollar to
depreciate immediately by 10 percent. Specifically, this risk premium shock to the dollar
raises the expected return that investors demand on assets denominated in dollars relative to
assets denominated in foreign currencies. The solid line denotes our preferred specification,
which entails low pass-through to import prices both at home and abroad, while the dotted
line shows the specification with constant desired markups, which implies complete pass-
through to both U.S. and foreign import prices. Under either specification of pass-through, it
is assumed that monetary policy follows a standard Taylor rule. It is worth noting that the
Taylor rule reacts only to the four-quarter change in core consumer price inflation and the
output gap (actual minus potential gross domestic product); monetary policy does not
respond directly to the exchange rate.
As illustrated by Figure 1, the risk premium shock has broadly similar effects on the United
States under either specification of pass-through. In particular, the shock raises real net
exports, because the induced depreciation of the dollar raises the relative price of imported
goods and reduces the price of U.S. exports in foreign markets. This strengthening of real
net exports, in turn, boosts U.S. output. Moreover, consumer price inflation rises due both to
higher import prices and because the stimulus to activity raises the marginal costs of
domestic producers.
However, there are several important differences between the results under each
specification. First, import prices rise much less under the low pass-through scenario,
implying less "direct" upward pressure on consumer prices. Second, because the relative
price of imports rises by less and the price of U.S. exports in foreign markets also falls by
less under the low pass-through specification, there are somewhat smaller effects on net
exports and, hence, on real output. Third, there is a smaller degree of "indirect" pressure on
domestic inflation because of the smaller output response.11
The model simulation results are useful in two respects. First, they suggest that under an
empirically reasonable specification that seems consistent with the low pass-through to
import prices seen in U.S. data, the effects of even a relatively large and sharp 10 percent
decline in the dollar on output and inflation are fairly modest. In particular, the output gap
peaks at less than 1/2 percentage point above baseline, and the inflation rate peaks at only
about 1/4 percentage point above baseline. Thus, there seems to be a substantial disconnect
between the exchange rate depreciation and nominal demand. Second, a comparison across
specifications highlights the importance of adequately modeling the structural features that
determine the transmission from exchange rates to import prices. Under the specification
implying full pass-through, the comparatively large jump in import prices and strong stimulus
to activity results in a sizeable surge in inflation, even though long-term inflation expectations
remain anchored and agents are assumed to be fully cognizant of the monetary rule.
Conclusion
Now let me summarize the lessons from the empirical evidence on exchange rate
passthrough. Sizeable depreciations of the nominal exchange rate exert fairly small effects on
consumer prices across a wide set of industrial countries, and these effects have declined
over the past two decades. Exchange rate depreciations are thus likely to have less adverse
effects on inflation than they have had in the past. The empirical evidence also indicates that
pass-through from exchange rates to import prices is low and has declined markedly over the
past two decades. This evidence suggests that there may be a weaker relationship between
exchange rate fluctuations and nominal demand than prevailed in the past, which may make
it easier for monetary policy to stabilize inflation and real activity. Nevertheless, exchange
rate fluctuations can still have an effect on inflation and economic activity; hence, monetary
policy must continue to take these fluctuations into account to ensure that inflation
expectations remain well anchored and that fluctuations in economic activity are minimized.
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