rethinking the link between exchange rates & … slides...rough rules of thumb • boe rough...
TRANSCRIPT
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Rethinking the Link Between Exchange Rates &
Inflation: Misperceptions and New Approaches
Kristin Forbes
External MPC Member
Bank of England
EACBN discussion forum, Bank of England
28 September 2015
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Currency Wars
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Sterling Exchange Rate
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Comments Today
1. What do we Know?: Current Evidence on How Exchange Rate
Movements Affect Inflation
2. Misperceptions? • Pass-Through is Greater in Sectors with a Greater Import Content
• Pass-through is Greater in Sectors that are More Tradable and Internationally
Competitive
• Pass-Through is Constant Across Time
3. A New Approach: Consider The Shock Driving the Initial
Movement in the Exchange Rate
4. Conclusions
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Preview: New Approach Needed
• Independent research project with Ida Hjortsoe and Tsveti Nenova at BOE
– Paper: “The Shocks Matter: Improving our Estimates of Exchange Rate Pass-Through”
– Also draws from recent speech at MMF conference in Cardiff, “Much Ado About
Something Important….”
– Does not represent official BoE views
• Improves our framework for thinking about how exchange rates affect prices
– Need to start with the source of the shock
– Similar to thinking about oil price movements
– Intuitive that companies respond differently
– Can explain different pass-through at different times (crisis vs. today)
• Important implications for how we forecast inflation and set monetary policy
• COMMENTS APPRECIATED!
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What do we Know?: Current Evidence on How
Exchange Rate Movements Affect Inflation
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Extensive Academic Literature
• Many contributions to different aspects of pass-through
– Gopinath (2015): currency of invoicing
– Burnstein and Gopinath (2014) for overview
– Evidence that changes over time in different countries: Marazzi et al. (2005), Gagnon and Ihrig
(2004), Fleer et al. (2015)
• Many contributions to factors behind exchange rate movements
– Clarida and Gali (1994), Eichenbaum and Evans (1995), Engle (2013)
• Papers suggesting different exchange-rate shocks have different effects on economy
– Klein (1990), Astley, Pain and Smith (2009)
– Theoretical model: Corsetti, Leduc, and Dedola (2009)
– Empirical evidence: Corsetti, Leduc and Dedola (2008), Kirby and Meaning (2014), An and
Wang (2011), Shambaugh (2008)
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Exchange rate pass-through:
After movements in the sterling/euro exchange rate
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Rough Rules of Thumb
• BOE rough estimates:
– 1st stage pass-through to import prices: 60 – 90%, quick (about 1 year)
– 2nd stage pass-through to CPI: 30% based on import intensity of CPI,
slow (about 3-5 years)
– Overall pass-through coefficient: 20% - 30%
• Recent 17% appreciation → CPI↓ by 3% to 5% over several years
• But a closer looks suggests this is missing something….
– Some assumed patterns don’t hold up well in the data
– Rate of pass-through seems to change sharply over short-periods of
time
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3 Misperceptions
1. Pass-Through is Greater in Sectors with a Greater Import Content
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Check Using Micro Data
• Price data for 85 goods and services in UK headline CPI index
from 1996 through 2008
• Component-level regressions to calculate price sensitivity in each
sector to movements in sterling
– Controlling for changes in oil prices, foreign export prices, UK output
gap
– Estimate “sterling sensitivity” coefficient
• Are sectors with a higher import content more sensitive to
sterling’s fluctuations?
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Sterling Sensitivity & Import Intensity
Confirmed with
more formal
regression
analysis:
negative
correlation
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3 Misperceptions
1. Pass-Through is Greater in Sectors with a Greater Import Content
2. Pass-Through is Greater in Sectors that are More Tradable and Internationally
Competitive
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Check Using Micro Data
• Use same measure of sterling sensitivity
• Calculate “tradability” by comparing price levels of goods for 30
different CPI components in the UK and the EU15
– 2 measures of law-of-one price (LOOP), focusing on average price
levels and deviations
• Are sectors that are more tradable also more sensitive to
sterling’s fluctuations?
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Tradability (x-axis) and sterling sensitivity (y-axis)
Note: LOOP1 on x-axis (the low er the measure the
more tradable is the good); price sensitivity to
sterling on y-axis (the higher is the coefficient, the
more sensitive is the price of the good to sterling). If
LOOP1 w as a good measure of tradability you
should get a negative relationship.
Note: LOOP2 on x-axis (the low er the measure the
more tradable is the good); price sensitivity to
sterling on y-axis (the higher is the coefficient, the
more sensitive is the price of the good to sterling). If
LOOP2 w as a good measure of tradability you
should get a negative relationship.
LOOP 1 LOOP 2
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Tradability (x-axis) and sterling sensitivity (y-axis):
excluding energy, fruit and vegetables
Note: Narrow LOOP1 excluding energy and fruit
and vegetables and sterling sensitivity on x-axis.
Note: Narrow LOOP2 excluding energy and fruit
and vegetables and sterling sensitivity on x-axis.
LOOP 1 LOOP 2
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3 Misperceptions
1. Pass-Through is Greater in Sectors with a Greater Import Content
2. Pass-Through is Greater in Sectors that are More Tradable and Internationally
Competitive
3. Pass-through is Constant over Time
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Rolling 10-year Estimated Pass-Through to Inflation
Note: A higher coefficient implies that prices fall more in response to
an appreciation, i.e. greater exchange rate pass-through.
Calculation:
rolling 10-year
exchange rate
coefficient from
aggregate CPI
Phillips curve
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Rolling 10-year Estimated Pass-Through to Import Prices
Note: A higher coefficient implies that prices fall more in response to an appreciation,
i.e. greater exchange rate pass-through.
Calculation:
rolling 10-year
exchange rate
coefficient from
OLS regression
of UK import
prices on the
exchange rate
and foreign
export prices
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--not in a good place!
Where do we stand?
3 puzzles
Extremely frustrating
Are we missing something?
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A New Approach: Consider Why the
Exchange Rate Moved in the First Place
Work with Ida Hjortsoe and Tsveti Nenova, “The Shock Matters: Improving
Our Estimates of Exchange Rate Pass-Through”
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Approach
• SVAR model, quarterly data from 1993q1 to 2015q1
• 6 domestic & global shocks which can effect the ER & other variables
– UK supply -- Exogenous exchange rate
– UK demand -- Global supply
– UK monetary policy -- Global demand (broadly defined)
• Look at impact on 6 variables
– Exchange rate (nominal ERI) --Import prices
– Consumer prices --GDP
– Interest rates (shadow) --Foreign export prices
• Identification criteria
– Based on economic theory & small-open economy DSGE model (see paper)
– Zero short- and long-run restrictions plus sign restrictions
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Identification Restrictions
UK supply shock
UK demand shock
UK monetary policy shock
Exogenous exchange rate shock
Global supply shock
Global demand shock
Short-run restrictions
UK GDP + + _
UK CPI - + _ -
UK interest rate
+ + -/0
UK nominal ERI
+ + +
UK import prices
World (ex-UK) export prices
0 0 0 0 +
Long-run restrictions
UK GDP
0 0 0
0 UK CPI
UK interest rate
UK nominal ERI
UK import prices
World (ex-UK) export prices
0 0 0 0
Note: A ‘+’ (‘-’) sign indicates that the
impulse response of the variable in
question is restricted to be positive
(negative) in the quarter the shock
considered hits. A ‘0’ indicates that the
response of the variable in question is
restricted to be zero (either on impact
or in the long run).
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Scenario
• Sterling appreciates 1% after 4 quarters
– Set magnitude of shocks as needed
• Estimation details
– Bayesian methods with standard Minnesota priors
– Standard error, percentiles & confidence intervals based on Gibbs
sampling procedure, 10,000 repetitions
– 2 lags of endogenous variables
• preferred by Schwartz information criteria
• Results robust to 1 lag
– Sign restrictions imposed for 2 periods
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UK supply shock
0 20 40-4
-2
0
2
4
6GDP
0 20 40-3
-2
-1
0
1CPI
0 20 40-10
-5
0
5
10Shadow BR
0 20 40-5
0
5Exchange rate
0 20 40-5
0
5Import prices
0 20 40-5
0
5Foreign export prices
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UK demand shock
0 20 40
-0.5
0
0.5
GDP
0 20 40-1
-0.5
0
0.5
1CPI
0 20 40-0.4
-0.2
0
0.2
0.4
Shadow BR
0 20 40-4
-2
0
2
4Exchange rate
0 20 40-4
-2
0
2
4Import prices
0 20 40-4
-2
0
2
4Foreign export prices
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UK monetary policy shock
0 20 40
-0.5
0
0.5
GDP
0 20 40-1
-0.5
0
0.5
1CPI
0 20 40-0.4
-0.2
0
0.2
0.4
Shadow BR
0 20 40-4
-2
0
2
4Exchange rate
0 20 40-4
-2
0
2
4Import prices
0 20 40-4
-2
0
2
4Foreign export prices
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UK exchange rate shock
0 20 40
-0.5
0
0.5
GDP
0 20 40-1
-0.5
0
0.5
1CPI
0 20 40-0.4
-0.2
0
0.2
0.4
Shadow BR
0 20 40-4
-2
0
2
4Exchange rate
0 20 40-4
-2
0
2
4Import prices
0 20 40-4
-2
0
2
4Foreign export prices
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Global supply shock
0 20 40-2
0
2
4
6GDP
0 20 40-4
-2
0
2CPI
0 20 40-2
0
2
4Shadow BR
0 20 40-10
-5
0
5
10Exchange rate
0 20 40-10
-5
0
5
10Import prices
0 20 40-10
-5
0
5
10Foreign export prices
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Global “demand” shock
0 20 40-2
0
2
4
6GDP
0 20 40-4
-2
0
2CPI
0 20 40-2
0
2
4Shadow BR
0 20 40-10
-5
0
5
10Exchange rate
0 20 40-10
-5
0
5
10Import prices
0 20 40-10
-5
0
5
10Foreign export prices
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Pass-through to import prices by shock*
* Median ratio of import price response to exchange rate response
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Pass-through to consumer prices by shock*
* Median ratio of CPI response to exchange rate response
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Forecast error variance decomposition
Variable Horizon (quarters)
Proportion of variance explained by shocks to:
Supply Demand Monetary policy
Exchange rate
Foreign supply
Foreign demand
GDP 1 0.50 0.08 0.04 0.06 0.14 0.17
20 0.47 0.05 0.03 0.04 0.28 0.13
CPI 1 0.14 0.15 0.17 0.07 0.33 0.13
20 0.15 0.12 0.16 0.07 0.36 0.15
Shadow BR 1 0.22 0.10 0.07 0.12 0.25 0.25
20 0.21 0.09 0.08 0.05 0.29 0.28
Exchange rate 1 0.09 0.28 0.18 0.22 0.12 0.11
20 0.11 0.23 0.15 0.19 0.17 0.15
Import prices 1 0.08 0.11 0.22 0.12 0.23 0.24
20 0.08 0.10 0.19 0.12 0.26 0.26
Foreign export prices 1 0.00 0.00 0.00 0.00 0.48 0.52
20 0.01 0.01 0.01 0.00 0.46 0.51
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Historical Shock Decomposition of Changes in
Sterling ERI
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Shock decomposition of large exchange rate
changes and implied pass-through coefficientsShocks 1996/7
appreciation2007/8
depreciation2013-
appreciationFull sample
FEVD*
Supply 10% 21% 14% 10%Demand 33% 20% 22% 25%Monetary policy 19% 11% 17% 17%Exchange rate 24% 13% 0% 21%Global supply 6% 18% 25% 14%Global demand 8% 17% 23% 13%
Implied ERPT to import prices (not controlling for world export prices) -0.67 -0.86 -0.99 -0.79Implied ERPT to consumer prices (not controlling for world export prices) -0.08 -0.16 -0.18 -0.13
Implied ERPT to import prices (assuming 60% pass-through from world
export prices to import prices)** -0.69 -0.90 -0.63
Implied ERPT to consumer prices (with additional assumption of 30% CPI
import intensity)** -0.09 -0.17 -0.08
* Average FEV contribution of each shock over first eight quarters.
** Based on the actual peak-to-trough or trough-to-peak changes in sterling ERI and corresponding changes in world export prices including oil.
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Conclusions
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Key Points
• Challenges predicting how exchange rate movements affect inflation
– Some basic priors do not hold well
– Pass-through can change sharply over time
• Our approach puts more emphasis on the underlying reason why the exchange rate moves
– Not the full story—especially for differences across countries
– More work needed (apprec./deprec, non-linearities, time shifts)
– But important progress explaining changes in pass-through across time
• Particularly helpful to understand recent UK puzzles
• Should improve our ability to forecast inflation and adjust monetary policy appropriately in the future
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Extra
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Historical shock decomposition of changes in UK
import prices
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Historical shock decomposition of CPI inflation
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Historical shock decomposition of UK GDP growth
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Historical shock decomposition of shadow Bank
Rate (detrended)
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Historical shock decomposition of world (ex-UK)
export prices
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Pass-through to import prices by shock (detailed
table)
Period Percentile Supply DemandMonetary policy
Exchange rate
Global supply
Global demand
1 50 -0.4 -0.3 -0.6 -0.3 0.2 0.1
5 -2.8 -0.7 -3.7 -1.4 -7.2 -6.0
95 1.9 1.0 1.9 1.3 6.8 7.2
5 50 -0.67 -0.34 -0.84 -0.49 -1.28 -1.48
5 -3.01 -1.43 -3.44 -1.17 -6.59 -8.61
95 1.58 3.33 2.35 0.82 3.82 5.83
20 50 -0.61 -0.41 -0.91 -0.48 -1.11 -1.38
5 -3.83 -3.31 -5.83 -1.11 -6.45 -5.77
95 3.69 3.59 3.57 0.49 4.61 2.46
![Page 45: Rethinking the Link Between Exchange Rates & … slides...Rough Rules of Thumb • BOE rough estimates: –1st stage pass-through to import prices: 60 –90%, quick (about 1 year)](https://reader035.vdocuments.mx/reader035/viewer/2022071005/5fc28a4c472aaa28f878b9ca/html5/thumbnails/45.jpg)
Pass-through to consumer prices by shock (detailed
table)
Period Percentile Supply DemandMonetary policy
Exchange rate
Global supply
Global demand
1 50 0.0 0.1 -0.2 -0.1 0.1 0.0
5 -1.5 0.0 -1.6 -0.6 -1.8 -0.9
95 1.3 0.4 0.0 0.0 1.9 1.2
5 50 -0.20 0.18 -0.27 -0.10 -0.37 -0.22
5 -2.53 0.00 -2.23 -0.55 -2.49 -1.74
95 2.14 1.40 -0.03 -0.02 2.22 1.18
20 50 -0.08 0.21 -0.24 -0.12 -0.30 -0.20
5 -3.31 -1.36 -3.61 -0.58 -4.05 -1.98
95 3.26 1.99 3.65 -0.01 3.05 1.09