Bank for International Settlements publishes working paper identifying economy size and inflation as the main drivers of exchange rate pass-through

The Bank for International Settlements has published a working paper on what drives the pass-through of exchange rate movements into consumer prices, based on data spanning four decades and close to 100 economies. Using a combination of econometric estimates and random forests, the paper finds that the size of the economy and the level of inflation are the factors most strongly associated with exchange rate pass-through, followed by product homogeneity and exchange rate volatility. It also finds that pass-through has declined over time in advanced economies, with one-year pass-through falling from 7.6% over the full sample to 4.4% in the last decade, while pass-through in a broad group of emerging market and developing economies has remained around 17% to 20%. The analysis points to several non-linear relationships. Pass-through is modest when average inflation stays below 5%, rises materially at higher inflation rates, and follows a U-shaped relationship with exchange rate volatility, reaching its minimum at intermediate volatility levels. The paper also finds lower pass-through when imports are less concentrated in homogeneous goods such as food and fuel, and when economies are larger. On policy settings, pass-through is lowest when inflation is close to target, when the de facto exchange rate regime is either a managed or a free float, and when fiscal credibility is stronger, proxied by sound fiscal accounts, lower deficits and lower public debt.