The shocks matter: Improving our estimates of exchange rate pass-through

Abstract

A major challenge for monetary policy is predicting how exchange rate movements will impact inflation. We propose a new focus: directly incorporating the underlying shocks that cause exchange rate fluctuations when evaluating how these fluctuations “pass through” to import and consumer prices. A standard open-economy model shows that the relationship between exchange rates and prices depends on the shocks which cause the exchange rate to move. We build on this to develop a structural Vector Autoregression (SVAR) framework for a small open economy and apply it to the UK. We show that prices respond differently to exchange rate movements based on what caused the movements. For example, exchange rate pass-through is low in response to domestic demand shocks and relatively high in response to domestic monetary policy shocks. This framework can improve our ability to estimate how pass-through can change over short periods of time. For example, it can explain why sterling's post-crisis depreciation caused a sharper increase in prices than expected, while the effect of sterling's 2013–15 appreciation was more muted. We also apply this framework to forecast the extent of pass-through from sterling's sharp depreciation corresponding to the UK's vote to leave the European Union.