Exchange rate pass-through to prices

An excerpt from Selected Research and Policy Analysis Notes to be published soon:


·The exchange rate pass-through to prices increased recently, after being at a near-zero level from the beginning of the decade and after having declined for a prolonged period beforehand. A possible explanation for the increase is the enhancement of competition in recent years.

 

·The average of the estimated short term pass-through (6 months) from the NIS/USD exchange rate to inflation has been approximately 25 percent in recent years.

 

·In contrast to the past, the estimated pass-through to prices from appreciation—24 percent—is greater than the estimated pass-through from depreciation—14 percent.

 

The exchange rate pass-through to prices (hereinafter, “ERPT” or "pass-through") is defined as the change in prices deriving from a change in the exchange rate. When there is complete pass-through, a change in the exchange rate leads to a change in prices by the same percentage. It is generally referred to as short term ERPT, for several months, and as long term ERPT, for a year or more.

 

Identifying the level of the pass-through, its speed, and its mechanism is an important tool for making monetary decisions, as it makes it possible to identify inflationary pressures resulting from changes in the exchange rate.

 

The literature indicates that in recent decades, the pass-through declined in industrialized countries, including Israel. It was also found that in countries with an inflation targeting regime, the ERPT is lower than in others. Many researchers claim that the level of transmission is determined by the share of companies in the economy who price domestically sold goods in local currency terms as opposed to those who price their goods in the producers' currency terms—the higher the share of companies who price their products in the foreign producers' currency terms, the higher the ERPT will be. Based on other research, the pass-through level is also impacted by the level of competition in the market, the market structure, and distribution services in the importing countries.

 

This research estimates the short-term (6 months) pass-through from the NIS/USD exchange rate to overall inflation, to inflation excluding housing prices, and to inflation in terms of tradable and non-tradable prices. The ERPT is estimated using a rolling regression over a 4-year window, which makes it possible to follow changes in the pass-through over time. The estimation controls for oil prices and the prices of imported consumer goods in dollar terms, as is customary in the professional literature.

 

It was found that in recent years, the ERPT to inflation increased, after a long period during which its level was near-zero. From the middle of 2017, the ERPT level rose to 25 percent, indicating that a 1 percent change in the exchange rate leads within a half year to a change of 0.25 percent in prices (Figure1).

 

The research also estimates the difference between the price response to depreciation and to appreciation. For most of the sample period, the pass-through from depreciation was higher than the pass-through from appreciation, indicating that companies tend to revise their prices upward in response to a depreciation to a greater extent than they tend to revise their prices downward in response to an appreciation. However, recently, this trend has reversed, and the pass-through from appreciation—24 percent—was higher than the pass-through from depreciation—14 percent (Figure 2). It is possibly a result of increased competition in the tradable goods sectors.  Firms in a competitive market will be more willing to reduce the price of their goods along with the reduction in their costs, thus maintaining their market share.

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