Exchange-Rate Pass-Through and US Prices
The prospect that monetary policy in the United States will soon tighten while monetary policy in Europe, Japan, and many other countries eases has launched the dollar skyward in foreign-exchange markets. Some worry that the price impacts of the dollar’s appreciation will push an already soft US inflation rate deeper into negative territory. The threat is real, but certainly overblown. Most of the change in import prices reflects declines in petroleum products, which have not been driven by exchange-rate movements. So we focus instead on nonpetroleum imports to show how the dollar’s appreciation is passing through to import prices and on to the CPI.
Dollar appreciations can have both direct and secondary impacts on import prices; consequently their effects can linger. All else constant, an appreciation will quickly lower the dollar price of goods produced abroad and priced at their source in foreign currencies. In addition, the dollar appreciation will raise the foreign-currency price of US exports. Together, these direct price impacts will shift global demand—both US and foreign—away from goods and services produced in the United States and toward those produced abroad. This shift in demand can then induce secondary price effects, raising the foreign-currency price of US imports. These secondary effects—often based on the strategic decisions of foreign producers—can offset, or even negate, the direct price effects from a dollar appreciation. Our rough calculations, which are consistent with previous findings, suggest that, in general, a jump in dollar exchange rates can affect import prices for at least six months, but that the overall impact is fairly small. A 1 percent change in the Board of Governor’s broad dollar exchange-rate index lowers non-petroleum import prices by 0.3 percent cumulatively over six months.
Exchange-rate movements have always had less of an effect on US import prices than on other countries’ import prices because roughly 95 percent1 of the goods coming into the United States are priced in dollars, not in foreign currencies, making them impervious to the vicissitudes of exchange rates. International trade in standardized commodities, such as agricultural and petroleum products, and goods sold in highly competitive markets is typically denominated in dollars, even when that trade does not involve Americans. In contrast, international trade in diverse manufactured goods, where price competition is less rigorous, tends to be set in the exporters' currencies. How exchange-rate changes affect these goods depends on the producers’ responses. As demand shifts from the United States to foreign-made products, foreign manufacturers may boost their prices, offsetting the exchange-rate effects to US consumers. How producers respond depends on many industry-specific factors, notably capacity utilization, but the larger and the more persistent the exchange-rate change, the more likely producers will respond.
Economists have noted that the pass-through of exchange-rate changes to import prices, both in the United States and in many other countries, has declined over the past 40 years. They attribute this trend in large part to a decline in global inflation, which has bolstered central-bank credibility and has lessened exchange-rate volatility. When the environment is more stable, firms resist quickly passing exchange-rate changes on to prices. In addition, China’s rise as a major low-cost global competitor has made many firms wary about changing their prices. Increased facilities for hedging exchange-rate movements may also allow firms to delay—and possibly avoid—passing exchange-rate movements on to prices.
Still, large exchange-rate movements can induce price effects, as we are beginning to see. From its trough in early July through the end of December 2014—a date that facilitates comparisons with available import-price data—the dollar appreciated 9.0 percent on a broad trade-weighted basis. Over that same period, total import prices fell by 9.7 percent, but nonpetroleum import prices fell only 1.3 percent. Our rough estimates of the effects of exchange-rate changes on nonpetroleum import prices suggest that virtually the entire decline in these prices reflects the dollar’s appreciation. (We estimated a 1.6 percent change in nonpetroleum import prices, all else constant.) A further drop seems likely in February.
Estimating the impact of the dollar’s appreciation on consumer prices—as passed through from import prices—is very difficult because it depends critically on what is causing the exchange rate to change in the first place. Higher inflation abroad, for example, might lead to an immediate dollar appreciation and—for a time—lower dollar import prices. The appreciation could have a temporary, broader effect on US consumer prices, but it would not cause deflation in the United States. That would require a tightening of US monetary policy. In the present situation, the dollar’s appreciation seems largely the result of an anticipated tightening of US monetary policy relative to monetary policies abroad and that tightening itself may eventually affect US consumer prices. The appreciation in part seems a near-term conduit of that change, not so much an independent cause, because exchange rates typically react faster to expected monetary-policy changes than goods prices.
With that caveat in mind, we find a small impact on the CPI. Between July 2014 and January 2015, as nonpetroleum import prices fell 1.3 percent, the CPI fell 1.2 percent. The entire decline in the CPI stemmed from a substantial drop in petroleum products; the CPI less energy rose 0.6 percent. Our rough estimates suggest that absent the decline in nonpetroleum import prices, all of which we ascribed to the dollar’s appreciation, the CPI less energy would have risen an additional 0.05 to 0.06 percentage point. The impact on the CPI would have been slightly less.
1. This percent is from the Bureau of Labor Statistics and pertains to the twelve months ending in September 2014. See also: The Internationalization of the Dollar and Trade Balance Adjustment.