Exchange-Rate Pass-Through to Import Prices
A dollar depreciation—like the broad-based, 26 percent one that we have experienced since February 2002—tends to raise the dollar price of all goods and services imported into the United States. Typically, however, less than the full amount of a dollar depreciation gets passed through to the dollar prices of imports. Interestingly, the amount of pass-through, both in the United States and other industrial countries, seems to have declined along with the level and volatility of worldwide inflation.
Most firms engaged in international trade do not conform closely with the economists’ ideal of being perfectly competitive. Firms exporting to the United States typically can mark up their homes-currency prices above their marginal costs and earn significant economic profits. Such firms can—and most likely will—react to a dollar depreciation by cutting their profit margins, at least temporarily, to protect their U.S. market share. As a consequence, U.S. consumers often will not see the full percentage of a dollar depreciation reflected in dollar-denominated import prices.
How much of the exchange-rate depreciation eventually gets passed through to dollar import prices depends on myriad industry-specific things that influence the responsiveness of demand and production costs to price and output changes. In addition, the size and expected duration of an exchange-rate change, as well as its direction, seem important. As one might then expect, estimates of pass-through at the industry level show a great deal of variation.
Likewise, estimates of pass-through for the overall economy show wide variation, so much so that we find it hard to specify their central tendency. Going out of a limb—and it’s a slim one at that—pass-through in the Unites States seems to have been less than 60 percent on average since the inception of floating exchange rates in 1973. Moreover, pass-through in the United States seems low relative to other industrialized countries.
While specifying a central tendency for pass-through in the United States is difficult, the evidence seems to indicate more clearly that U.S. pass-through has fallen by roughly one-half during the 1990s. Researchers note a similar pattern in many other industrialized countries.
In part, this might just reflect changes in the composition of U.S. imports, away from industries that traditionally have had a high rate of pass-through to industries that traditionally have had a low rate of pass-through. In part, the declining rate of pass-through might reflect growing facilities for hedging exposures to unanticipated exchange-rate changes.
Yet, two other explanations seem to loom large. One is China’s growing influence in world markets. Because China pegged the renminbi to the dollar until 2005 and has since managed the renminbi’s movements, the dollar’s depreciation since 2002 has had less of a negative effect on China’s competitiveness than it has had on many other nation’s trade positions. Foreign firms may cut their price mark-ups more readily when they face Chinese competition.
The other—the dominant—explanation for a declining rate of pass-through contends that in an environment of low and stable inflation, foreign firms are more reluctant to pass through exchange-rate changes into dollar prices. International trading firms, despite having some pricing power, often face a cost to changing prices, in large part because price changes encourage customers to look elsewhere. Such firms will only change prices when the gains from doing so exceed the costs, so they will delay until they find that the exchange-rate change is substantial and permanent. In a high-inflation environment, permanent depreciations are more likely and the rising overall price level can quickly negate relative pricing errors.