After the pandemic, central banks faced the daunting challenge of stabilising prices as supply chain disruptions led to rising costs (Ostry et al. 2022) and geopolitical tensions (Ben Cheikh et al. 2023) and aggressive monetary tightening by the Federal Reserve led to significant fluctuations in exchange rates. All the while, policymakers at major central banks have warned that their economies face an unusual degree of uncertainty. This invites us to revisit an important question: How do exchange rate movements affect domestic prices in such an environment?
Recent studies have highlighted that the degree of exchange rate pass-through to domestic prices can vary significantly depending on the state of the economy. The literature suggests that pass-through is generally low in stable economic environments with credible central banks, but rises in other contexts (Valencia et al. 2017, Caselli and Roitman 2019, Gopinath et al. 2020, Ben Cheikh et al. 2023). Studies also find that different sources of exchange rate shocks can elicit varying price responses (Forbes et al. 2020, Comunale 2020, Ha et al. 2020). Understanding this variability in exchange rate pass-through is critical for policymakers, who must anticipate the inflationary impacts of exchange rate movements under current conditions.
Building on this literature, our research explores the state-dependent nature of exchange rate pass-through across a large sample of advanced and emerging market economies over the past three decades (Carrière-Swallow et al 2023). We find that pass-through is significantly higher during periods of elevated economic uncertainty and when inflation is already high.
Snapshot of exchange rate pass-through
We begin by assessing the strength of exchange rate pass-through into domestic prices, estimating impulse response functions using local projections on a sample of 46 countries since 1990. Our findings reveal that a 1% depreciation is associated with an increase in consumer prices of about 0.05% within one month, rising approximately 0.16% after one year. The result varies substantially across countries, with average pass-through of 0.08% after one year in advanced economies and of 0.3% in emerging market economies.
Pass-through to import prices is stronger, materialises more quickly, and is more uniform across income levels – averaging about 0.6% after only one month – consistent with findings by Burstein and Gopinath (2014) and Bonadio et al. (2016). Exchange rate fluctuations also affect core prices, with a pass-through coefficient of 0.08, which is roughly half the level observed for overall consumer prices. Additionally, exchange rate fluctuations impact inflation expectations – though to a lesser extent than consumer and import prices – with the effect peaking after seven months but remaining persistent at 0.07 percentage points after one year.
Figure 1 Average exchange rate pass-through into domestic prices
Source: Based on estimates reported in Carrière-Swallow et al (2023).
Notes: Estimates show the response of domestic prices after one year following a 1% increase (depreciation) in local currency per USD. Error bars denote confidence intervals at the 90% confidence level. Standard errors are clustered at the country level.
State-dependent exchange rate pass-through
We then explore how exchange rate pass-through varies depending on the state of the economy. First, we examine the role of inflation as a state variable. We find that the magnitude of the pass-through increases with the level of inflation, consistent with the earlier findings of Choudhri and Hakura (2006) and Valencia et al. (2017). We show that this increase in pass-through is non-linear, becoming substantially stronger when inflation exceeds the fourth quartile of the empirical distribution.
A novel finding from our research is the impact of uncertainty on exchange rate pass-through. Using the index of economic uncertainty compiled by Ahir et al. (2022), we find that pass-through is substantially higher during periods of elevated uncertainty. This finding is supported by models that link increased uncertainty to more frequent price adjustments, as firms facing nominal rigidities find themselves more frequently deviating from efficient pricing in an unpredictable inflation environment (Devereux and Yetman 2010).
Additionally, we observe that exchange rate pass-through is higher in countries with greater inflation forecast disagreement and with a larger share of imports invoiced in US dollars. Countries experiencing higher forecast disagreement – associated with periods of volatile inflation and low central bank credibility – tend to experience greater pass-through into domestic prices. Similarly, economies with a larger proportion of imports invoiced in US dollars experience stronger pass-through, reinforcing the dominant currency pricing theory (Gopinath et al. 2020).
Figure 2 State-dependent exchange rate pass-through
Sources: Based on estimates reported in Carrière-Swallow et al (2023).
Note: Estimates show the response of headline CPI across different states against a 1% increase (depreciation) in local currency per USD. Error bars denote confidence intervals at the 90% confidence level. Standard errors are clustered at the country level.
Shock-dependent exchange rate pass-through
Our analysis also demonstrates that the rate of exchange rate pass-through varies depending on the source, sign, and size of exchange rate shocks. When investigating the asymmetry in exchange rate pass-through, we find that pass-through materialises faster following depreciations than appreciations. We then consider non-linearity in the size of exchange rate shocks, and observe that larger depreciations result in somewhat higher pass-through rates: a 25% depreciation leads to a stronger pass-through to domestic prices (0.2) than a 1% depreciation (0.16).
Finally, we explore whether exchange rate pass-through varies according to the shocks driving exchange rate fluctuations. To identify the impact of US monetary policy on the exchange rate, we construct an instrument by interacting US monetary policy shocks with country-specific measures of the exchange rate regime and capital account openness, which captures the role of the portfolio investment channel. Our identifying assumption is that this channel will be a strong conduit for US monetary policy shocks to exchange rates of countries with more open capital accounts and flexible exchange rate regimes, but not to others. We find that pass-through is much stronger when exchange rate fluctuations are caused by US monetary policy shocks than when they are caused by other disturbances. The pass-through coefficient reaches 0.47 after one year, which contrasts with the average pass-through coefficient of 0.16 from our baseline regression results. This finding aligns with previous studies and underscores the importance of considering the source of exchange rate fluctuations when assessing their impact on domestic prices.
Figure 3 Shock-dependent exchange rate pass-through
Note: Blue line presents the coefficient of the response of consumer prices following a 1% exchange rate depreciation caused by a shock to US monetary policy.
Conclusion
Our study provides empirical evidence on the state- and shock-dependent nature of exchange rate pass-through. With the global economy facing heightened uncertainty and inflationary pressures, estimates about the stability of exchange rate pass-through based on data from normal times may not hold. Policymakers need to adapt their strategies to account for the variability in pass-through effects, particularly in times of economic uncertainty.
References
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Ben Cheikh, N, Y Ben Zaied, and H Ben Ameur (2023), “Recent Developments in Exchange Rate Pass-Through: What Have We Learned from Uncertain Times?”, Journal of International Money and Finance 131: 102805.
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Burstein, A and G Gopinath (2014), “International Prices and Exchange Rates,” Chapter 7 in Handbook of International Economics, Vol. 4: 391–451.
Carrière-Swallow, Y, M Firat, D Furceri, and D Jiménez (2023), “State-Dependent Exchange Rate Pass-Through”, IMF Working Paper 23/86.
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