A quarter century of inflation targeting & structural change in exchange rate pass-through: Evidence from the first three movers

Abstract

This study analyses the implications of Inflation Targeting (I.T.) for the Exchange Rate Pass-Through (ERPT) to inflation and trade balance by focusing on the first three movers i.e. New Zealand, UK and Canada. Drawing on the monthly data from October 1976 to September 2017, we employ a TVSVAR framework. Our key findings suggest that there is significant evidence of time-variation in the ERPT to inflation and trade balance in all three countries. Contrary to the notion that the ERPT to inflation has decreased under inflation targeting, in fact, there is strong evidence that if there is anything, it is the other way round. The ADF unit root test with a structural break suggests that the oscillations in coefficients for inflation show a decrease and the timing corresponds to the start of I.T. However, this coincident cannot lead to infer that the ERPT has lost its significance. There is also a considerable amount of heterogeneity in the ERPT in the under-analysis countries. Specifically, in response to the positive Real Effective Exchange Rate (REER) shock, the inflation fell in the UK and New Zealand whereas, in Canada, it had the opposite effect. On the ERPT to the trade balance, the results on the UK showed clear evidence of J-curve whereas in Canada, the impact was rather instantaneous, and the trade balance quickly deteriorated. In New Zealand, the trade balance also showed deterioration in response to the REER shocks, although comparatively there was milder response than Canada and the UK. Our findings have profound implications for monetary policy formulation under I.T. regimes and the influence of ERPT on price stability and external balance.

Inflation targeting & implications of oil shocks for inflation expectations in oil-importing and exporting economies: Evidence from three Nordic Kingdoms

“…Thirdly, the real effective exchange rate found to have a significant impact in all three countries suggesting the exchange rate pass-through to inflation expectation. These findings are in line with the study by Forbes (2016); Forbes et al (2017Forbes et al ( , 2018; Nasir et al ( , 2020a; Nasir & Vo (2020) which have argued that ERPT to inflation persists regardless of inflation targeting. More specifically, our findings are in line with Nasir et al (2020a) which suggested significant ERPT to inflation expectation in the Czech Republic.…”

Forecasting inflation under uncertainty: The forgotten dog and the frisbee

“…There is a substantial amount of literature on the impact of exchange rate dynamics on inflation, including the evidence on the UK (for instance, see Menon, 1995;Goldberg and Knetter, 1997;Hänninen and Toppinen, 1999;Campa and Goldberg, 2005;Choudhri and Hakura, 2006;Bache, 2006;Mumtaz et al, 2006;Bhattarai, 2011;Wimanda et al 2011;Burnstein and Gopinath, 2013;Forbes, 2014;Forbes, 2016;2015a;Yildirim and Ivrendi, 2016;Nasir and Simpson, 2018;Nasir and Vo, 2020;Nasir et al 2020aNasir et al , 2020b. Despite the substantial evidence on the subject, the existing models and estimates have substantial limitations and particularly when it comes to UK data on the exchange rate pass-through there are major divergences between the prevailing wisdom on the nexus between inflation and exchange rate and what is actually observed.…”

“…Therefore, monetary policy must continue to take these fluctuations into account to ensure that inflation expectations remain well-anchored. In fact, contrary to the Mishkin (2008) idea that the exchange rate pass-through might have reduced, Forbes (2015a), Nasir and Simpson (2018) and Nasir and Vo (2020) raised the possibility that exchange rate pass-through may be occurring faster today than in the past, accelerating the immediate impact on inflation. The similar argument was made by Fisher (2015) suggesting that the Federal Reserve Board assumes a substantially faster rate of pass-through to inflation.…”

“…This led to the earlier cited historical sharp depreciation of Sterling. As the Bank of England revised its forecast on the outlook for the GDP, despite the sharpest depreciation which has theoretically and empirical positive effects on the rate of inflation (Bhattarai, 2011;Wimanda et al 2011;Forbes, 2016;Forbes, 2015a;Yildirim and Ivrendi, 2016;Simpson, 2018, Nasir andVo, 2020) the inflation forecast was not subject to any revisions, as suggested in Figure 3. Nevertheless, the values of the numerical parameters of inflation report probability distributions (Appendix A) did not show much difference as compared to the values presented in the pre-Brexit (May) inflation report.…”

“…It is prima facie evident that the forecast did not take into account the depreciation of Sterling. There is a vast empirical literature on the pass-through of exchange rates depreciation (See Menon, 1995;Goldberg and Knetter, 1997;Hänninen and Toppinen, 1999;Campa and Goldberg, 2005;Choudhri and Hakura, 2006;Bache, 2006;Mumtaz et al, 2006;Burnstein and Gopinath, 2013;Forbes, 2016;2015a;Nasir and Simpson 2018;Nasir and Vo 2020;Nasir et al 2020aNasir et al , 2020b) which showed various degrees of impact of exchange rates on inflation. Interestingly, the BoE herself has estimated the exchange rate pass-through, and in Forbes (2016) words:…”