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Exchange rate pass-through and inflation trends in developing countries

Extract from GEP June 2014 - Special topic

Two episodes of global financial turbulence over the past 13 months saw capital flows decelerate and a number of developing-country currencies depreciate. In parallel, developing-country inflation remained elevated, on average, increasing to 7.4 percent in 2013, up from 6.4 percent in 2012 and an average of 6 percent over the last decade (see figure 1).

The persistence of high inflation in an environment characterized by stable or even declining commodity prices reflects a variety of influences, including supply side bottlenecks, country-specific developments and, in the most recent period, adjustments to past exchange rate depreciations.

This special feature analyzes the link between currency and inflation patterns across developing economies, based on estimates of the size and timing of the exchange rate pass-through in 45 middle and low income countries. It breaks out the relative contribution of exchange rate movements and domestic cyclical conditions to recent inflation trends and presents inflation projections for 2014 and 2015.

The analysis concludes that currency-related price pressures are mainly concentrated in a few large middle income economies, including Argentina, Venezuela, Turkey, Ghana, South Africa, Indonesia or India (see figure 2). Higher inflation in these economies is influencing regional aggregates, whereas markedly different patterns are observed in other countries.

Reflecting the recent stabilization of foreign exchange markets, the inflationary impact of past depreciations is expected in most cases to peak around mid-2014, implying that developing-country inflation could be expected to moderate later this year and throughout  2015 (see figure 3)—barring further episodes of exchange rate volatility.

From a policy perspective, a low exchange rate pass-through helps to limit the impact of currency fluctuations on domestic demand and allows exchange rate adjustments to play a greater role in absorbing external shocks without undermining price or output stability. Evidence of lower pass-through rates among developing countries with inflation targeting central banks suggests the importance of credibly anchoring inflation expectations.

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FIGURE 1 Inflation decoupling between developing and high-income countries
Source: Haver,World Bank.
FIGURE 2 Exchange rate impact on current inflation (April 2014) across developing countries
Source: World Bank.
FIGURE 3 Outlook for inflation in developing country (exc. China) and main contributing factors
Source: World Bank.