Exchange rate pass-through to domestic inflation in developing countries
Two episodes of global financial turbulence over the past 12 months have caused capital flows to slow temporarily, forcing sharp depreciations of the currencies of several countries with large current account deficits. A their peak, depreciations exceeded 10 percent in nominal effective terms in 16 developing countries, although many currencies have recovered value since then (figure B9.1).
Partly because of higher import prices, inflation in many of these countries has remained elevated or increased. Econometric analysis of exchange rate pass-through to headline inflation in 45 developing economies (see Special Topic) suggests that the depreciations that have been observed in a number of middle income countries has contributed directly to keeping inflation high. Controlling for the degree of economic slack, a 10 percent depreciation (in trade weighted terms) will, on average, lead to a 3 percentage point increase in inflation (figure B9.2) after 10 to 11 months, before gradually dying down afterwards.
Confirming previous empirical findings (Gagnon and Ihrig 2004, Reyes 2004, Schmidt-Hebbel and Tapia 2002) the analysis shows that inflation in developing countries tend to be more sensitive to currency fluctuations when compared with high income countries. However, inflation impacts are much smaller for developing countries with central banks that have instituted credible inflation targeting regimes — a result that suggests the importance of anchoring inflation expectations in maintaining price stability and minimizing the inflationary impact of currency fluctuations. Countries that have earned such credibility can more easily tolerate exchange rate adjustments as a way of absorbing external shocks and regain autonomy in monetary policy decisions.
Among domestic factors conditioning the final impact of exchange rate developments on subsequent inflation, the degree of economic slack is crucial and can either reinforce or conversely offset the effect on domestic price pressures. A taxonomy of the timing of depreciation (whether occurring in the second half of 2013 or in the first four months of 2014) and projected output gaps in 2014 (to assess the degree of demand-side pressures) helps to identify countries where inflation pressures are likely to be sustained going forward, and where they are likely to fade. Inflationary pressures are likely to be sustained in countries where output gaps are positive or modestly negative (less than 0.5 percent of potential GDP) — Quadrants I and II of figure B9.3. For those that experienced continued currency pressures during 2013 and 2014, inflation pass-through effects from exchange rate depreciations are likely to peak toward the end of 2014 (Argentina, Ghana, Mongolia, Turkey and Zambia). In contrast, countries in Quadrants III and IV where negative output gaps are significant are likely to see inflation pressures abate relatively earlier.
The large currency depreciations of some countries have begun to unwind as financial tensions have eased (see figure B9.1). All else equal, inflation pressures should begin to ease soon for countries that experienced the bulk of the depreciation during 2013 and where currency gains since the start of the year have been the most marked. For these countries, the inflation impacts associated with currency depreciations should begin to fade in the second half of 2014. Among countries, that endured significant depreciations in the first quarter of 2014 (notably, Argentina, Ghana, Ukraine or Kazakhstan), inflationary pressures are likely to keep building until they begin to subside late this year.