FRBSF Economic Letter
2004-21; August 13, 2004
Does a Fall in the Dollar Mean Higher U.S. Consumer Prices?
Beginning in early 2002, the
dollar tumbled against major currencies like the euro, the British
pound, and the Japanese yen; though it has risen somewhat in recent
months, it is still well below that peak. One of the key questions
this has raised for U.S. monetary policymakers is: How much of
the decline in the dollar passed through to import prices and to
overall consumer prices?
This Economic Letter looks at the relationship
among changes in the exchange rate value of the dollar and in
import prices and
overall consumer prices, with a particular focus on the current
circumstances. It appears that the lower value of the dollar
at this point is affecting U.S. prices less than it has historically.
The reasons for the difference include changes in trading partners,
changes in the composition of U.S. trade, and improved monetary
policy over the last several years. Looking ahead, then, it appears
likely that the recent dollar depreciation will have only very
moderate effects on overall consumer prices.
How changes in the dollar "pass
through" to U.S. prices
Between February 2002 and May 2004, the real value of the dollar
fell by 19.1% relative to the other G-7 currencies (Canada, Japan,
France, Germany, Italy, and the United Kingdom). However, import
prices did not respond by jumping by 19.1% as well. Rather, only
a part of the dollar's decline "passed through" to import
prices. The reasoning is as follows. Import prices reflect the
costs in dollars of purchasing goods produced in other countries.
Such costs depend on the cost of production, the cost of distributing
the good, the profit margin desired by the foreign exporter, and
the exchange rate. The pass-through rate may be less than 100%
for a given devaluation, holding production costs and other factors
constant, because the foreign exporters may be willing to reduce
their profit margins.
A crude way to estimate the pass-through rate
is to compare the cumulative changes in the exchange rate and
import prices. Non-oil
import prices and non-energy consumer prices increased by only
4.1% between February 2002 and May 2004. The recent 19.1% depreciation
of the dollar against major (G-7 industrial) currencies implies
a modest 21% pass-through rate.
More sophisticated empirical
studies take account of possible lags in the effect of currency
depreciation on import prices
and also
control for movements in import prices that are unrelated to
changes in the exchange rate. These studies find that the average
pass-through
rate for industrialized countries is about 60%, with the greatest
effect occurring within four quarters of the change in the
exchange rate (Goldberg and Knetter 1997).
It is well documented
that the United States has a lower pass-through rate than most
industrialized countries, because foreign exporters
are more willing to keep prices to U.S. consumers constant
in order to maintain market share. Based on data from the
mid-1970s through
the 1990s, the pass-through rate for the United States is
estimated to be about 40% (see Olivei 2002 and Campa and Goldberg
2002).
Thus, a depreciation of 19.1% should result in a 7.6% increase
in import prices, well above the 4.1% observed over the last
two years. This suggests that import prices could increase
by
an additional
3.5% in order to match the historical U.S. pass-through rate.
However, several factors in the current economic environment
suggest that
it is unlikely that the U.S. will see a rise of that magnitude
in import prices.
Changing trade partners
Historically, the U.S.'s main trading partners have been the G-7
countries; but globalization, especially over the last few years,
has broadened the group of trading partners substantially. For
example, China and Mexico now account for a significant share of
total U.S. imports—up from a 5.5% share in 1980 to a 22.4% share
in 2002. Therefore, it makes sense to measure the change in the
dollar's exchange rate value not simply vis-à-vis the G-7,
but rather against a broader trade-weighted basket of currencies.
By that measure, the dollar has depreciated by only 9.3%; for example,
the Chinese renminbi has remained constant against the dollar and
the Mexican peso has actually fallen by 25.6%. Therefore, taking
the smaller rate of depreciation together with a 40% pass-through
rate implies only a 3.7% increase in import prices, which is reasonably
close to the 4.1% increase we have seen so far.
Changing composition of U.S. imports
The composition of imports is another important determinant of
the magnitude of the pass-through effect. Campa and Goldberg (2002)
document that pass-through rates vary dramatically among products
and across industrialized countries (including the U.S.). Olivei
(2002) examines a cross section of U.S. industrial imports and
finds that estimates of pass-through rates vary from 15% for electronics
to 90% for raw materials.
The main reason for these differences
is the degree of competition in those markets. Firms with more
market power may prefer to cut
into their profit margins (markup) rather than raise prices in
response to cost shocks to avoid losing market share. The more
market power a foreign exporter has, the less it will pass cost
changes due to an exchange rate change through to the price charged
to consumers.
The U.S. has seen some movement in the composition
of imports into products that have low pass-through rates, implying
that the impact
of the dollar's depreciation on import prices and consumer prices
should also be restrained. Specifically, the share of capital
goods (excluding automotive goods) in U.S. non-energy imports increased
from 19% in 1980 to 32% in 2000. Meanwhile, the share of non-energy
industrial supplies fell from 29% to 14% over the same period.
Since pass-through rates for capital goods are lower than for
industrial
supplies, which include raw materials, the average pass-through
rate should decline. Indeed, Olivei (2002) finds that, for the
U.S., the average pass-through rate for a broad selection of
industrial products has declined from the historical 40% to 22%
in sample
periods limited to the 1990s. Using the lower pass-through rate
and the 9.3% depreciation against the broader basket of currencies
implies a 2% increase in import prices, which is actually lower
than the recent 4.1% change.
How changes in import
prices pass through to overall consumer prices
To estimate the impact of a change in import prices on overall
consumer prices, it would be tempting to assume that it would be
directly proportional to the share of imports in total output.
In other words, since imports represent about 14% of total U.S.
output, one might simply assume that they also represent 14% of
consumer prices; then, with a 4.1% increase in import prices, we
could expect a 0.6% increase in overall consumer prices.
However,
one cannot directly compare changes in exchange rates, import
prices, and consumer prices. Changes in the monetary policy
regime or in the nature of external shocks also may play a role.
To the extent that they do, this implies that the estimated pass-through
rates may change over time along with changes in these underlying
factors.
For example, suppose the Fed tightened monetary policy
in response to higher expected inflation after a period of exchange
rate
depreciation. If consumer prices did not rise much, even though
the currency
depreciated, estimated pass-through rates would appear lower
because of the monetary policy action. This implies that monetary
regime
changes that involve a more aggressive stance towards inflation
can lead to lower observed pass-through rates. This has been
the case in high-inflation developing countries, where monetary
policy
reforms have been accompanied by lower pass-through rates to
domestic prices (Choudhri and Hakura 2001).
External shocks
may also affect estimated pass-through rates. For example, when
oil prices soared in the 1970s, the dollar
depreciated
sharply, and import prices and inflation increased. This
created the appearance of a high pass-through rate. However, as
oil
prices returned to more normal levels, the observed pass-through
rate
into overall consumer prices also returned to more normal
levels.
Gagnon and Ihrig (2002) provide evidence on how external
shocks may affect the relationship of the dollar exchange
rate and
final prices. Using data from 1971 to 2000 that includes
the major
oil price shocks of 1973-1974 and 1978-1979, they found
results suggesting
that a 9.3% dollar depreciation would be associated with
a 2.5% increase in overall consumer prices. However, when
their
sample
was restricted to the post-oil shock period of 1981 to
2000, a 9.3% depreciation is associated with only a 0.3% increase
in consumer
prices. This is lower than the simple estimates based on
the share of imports in total output.
Conclusion
Between February 2002 and May 2004, the dollar depreciated by
19.1% against a basket of major currencies. However, over the same
period it depreciated by only 9.3% against a broader basket of
currencies. Furthermore, the pass-through rate from the exchange
rate to import prices and consumer prices has declined as the share
of low pass-through imports has increased. Taken together, these
observations suggest that import prices may not rise much further
in response to the recent dollar depreciation. Given the small
relative importance of the import sector in the U.S. economy, together
with a reduced pass-through rate into consumer prices, the effect
of any further import price increases on the overall price level
is likely to be very moderate.
Diego Valderrama
Economist
References
[URLs accessed August 2004.]
Campa, José Manuel, and Linda Goldberg.
2002. "Exchange Rate Pass-Through into Import Prices: A Macro
or Micro Phenomenon?" NBER Working Paper 8934. http://papers.nber.org/papers/w8934.pdf
Choudhri, Ehasn U., and Dalia S. Hakura. 2001. "Exchange
Rate Pass-Through to Domestic Prices: Does the Inflationary Environment
Matter?" International Monetary Fund Working Paper 01-194
(December). http://www.imf.org/external/pubs/ft/wp/2001/wp01194.pdf
Gagnon, Joseph E., and Jane Ihrig. 2002. "Monetary
Policy and Exchange Rate Pass-Through." Federal Reserve Board
of Governors, International Finance Discussion Paper 2001-704 http://www.federalreserve.gov/pubs/ifdp/2001/704/ifdp704r.pdf
Goldberg, Pinelopi, and Michael Knetter. 1997. "Goods
Prices and Exchange Rates: What Have We Learned?" Journal
of Economic Literature 35 (September) pp. 1243-1292.
Olivei, Giovanni P. 2002. "Exchange Rates
and the Prices of Manufacturing Products Imported into the United
States." New England Economic Review (1st Quarter) pp. 3-18.
http://www.bos.frb.org/economic/neer/neer2002/neer102a.pdf
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