Exchange-rate pass-through refers to the percentage change in the price of imported goods in response to a 1% depreciation of the exchange rate. Imported goods make up 10% of all expenditure by UK households and firms. For this reason, understanding pass-through is crucial for gauging how fluctuations in the exchange rate may affect consumer and producer prices.
The degree of pass-through depends on the currency in which UK importers pay for foreign goods. For example, everything else constant, the price of goods that are paid for in sterling would be unaffected by a depreciation of the pound against a dollar, while the price of goods paid for in dollars would rise one-for-one with this depreciation of the pound.
Pass-through also depends on how the prices UK importers face are adjusted after an exchange-rate change. For example, even if an imported good is paid for in sterling, the foreign supplier may ask for a higher sterling price after a depreciation of the pound.
New research by Tommaso Aquilante and Robert Zymek, presented at the annual congress of the European Economic Association (EEA) in August 2020, investigates the relative importance of these two mechanisms for pass-through – and how it depends on the nature of exchange-rate fluctuations.
To do so, they use detailed data on all UK import transactions from non-EU countries between January 2010 and December 2017. This is confidential data recorded by HMRC to which they obtained access for the purposes of this analysis.
It is ideal to address the question for two reason. First, the data record the currency of invoicing for each import transaction. Second, in the period covered by the data, the UK's currency experienced both small ‘everyday’ fluctuations as well as three large unexpected depreciations. These large depreciations occurred in May 2010, July 2016, and October 2016. They make it possible to test whether pass-through differs in such episodes relative to what is observed in response to the everyday ups-and-downs of sterling.
The researchers find that this is indeed the case. In ‘normal times’, pass-through patterns can be explained almost entirely by the currency in which UK imports are invoiced. This is consistent with the notion that imported-goods prices are ‘sticky’ in their invoicing currency: the contracted prices do not respond to small exchange-rate movements.
But the empirical analysis suggests that these prices are actively adjusted after large unexpected depreciations. As a result of this adjustment, overall pass-through is around 30% higher. This can help explain why, for example, other studies have reported a very strong response of UK prices to large sterling depreciations.
On the basis of transactions-level data, this study provides strong evidence that exchange-rate pass-through may be highly contingent on the size of exchange-rate movements. This finding may be one reason why historical estimates of UK exchange-rate pass-through, based on macro data, have varied significantly across periods. It is also potentially important for forecasting the price effect of future exchange-rate fluctuations that may result from uncertainty about UK trade policy and the trajectory of the global economy.
ENDS
Authors:
Tommaso Aquilante
Bank of England and Centre for Macroeconomics*
https://sites.google.com/site/tomaquilante/home. Blog posts here.
@TommasoAquilan3 on Twitter
Robert Zymek
University of Edinburgh and CESifo**
Tel. (+44) 0131 650 6953
@RobertZymek on Twitter
* Threadneedle Street, London, EC2R 8AH, United Kingdom; tommaso.aquilante@bankofengland.co.uk.
** 31 Buccleuch Place, Edinburgh, EH8 9JT, United Kingdom; robert.zymek@ed.ac.uk.