Series: Occasional Papers. 2016.
Author: Eva Ortega and Chiara Osbat.
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Abstract
Aggregate exchange rate pass-through (ERPT) to import and consumer prices in the EU is
currently lower than it was in the 1990s and is non-linear. Low estimated aggregate ERPT to
consumer prices does not at all mean that exchange rate movements do not have an impact
on inflation, as aggregate rules of thumb mask substantial heterogeneities across countries,
industries and time periods owing to structural, cyclical and policy factors. Looking also at
new micro evidence, four key structural characteristics explain ERPT across industries or
sectors: (i) import content of consumption, (ii) share of imports invoiced in own currency
or in a third dominant currency, (iii) integration of a country and its trading partners in global
value chains, and (iv) market power. In the existing literature there is also a robust evidence
across models showing that each shock which causes the exchange rate to move has a
different price response, meaning that the combination of shocks that lies behind the cycle
at any point in time has an impact on ERPT.
Finally, monetary policy itself affects ERPT. Credible and aggressive monetary policy reduces
the observed ex post ERPT, as agents expect monetary policy to counteract deviations of
inflation from target, including those relating to exchange rate fluctuations. Moreover, under
the effective lower bound, credible non-standard monetary policy actions result in greater
ERPT to consumer prices. This paper recommends moving away from rule-of-thumb
estimates and instead using structural models with sufficient feedback loops, taking into
account the role of expectations and monetary policy reactions, to assess the impact of
exchange rate changes when forecasting inflation.