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.

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