Is exchange rate depreciation inflationary?

Whether or not exchange rate depreciation is inflationary is important to forecast monetary policy developments. Do central banks react if the country’s exchange rate depreciates? The economic literature 1 reminds us that exchange rate pass-through (ERPT, or the effect of the exchange rate on inflation ) is weak: If the central bank tightly controls inflation (but this implies that depreciation was inflationary before monetary policy reacted ); In the presence of strong competition in the country’s domestic market: if competition is strong, foreign companies that export to the country cannot increase their prices when the country’s exchange rate depreciates and must squeeze their profit margins; In the presence of a weak differentiation of the country’s imports: if imported products differ from products manufactured domestically, exchange rate depreciation leads to a rise in the prices of imported products. We examine empirically the effect of exchange rate depreciation on inflation in the United States, the euro zone and Japan. Altogether, we find: Relatively significant exchange rate pass-through to core inflation in the United States; Weaker or even non-existent ERPT to core inflation in the euro zone and Japan, due to a smaller effect of import prices on core inflation. This suggests that in the United States, there is less competition in the goods market and greater differentiation of imports. This is consistent with the fact that the exchange rate has a n effect on monetary policy in the United States, but not in the euro zone or Japan. 1 See for example M. Bussière, S. Delle Chiaie, A.T. Peltonen (2014), “Exchange Rate Pass-Through in the Global Economy: The Role of Emerging Market Economies”, IMF Economic Review.