The Impact of the USD/EUR Exchange Rate on Inflation in CEE

Countries

Ljubinko Jankov, Ivo Krznar, Davor Kunovac, Maroje Lang

The Impact of the USD/EUR Exchange Rate on Inflation in CEE Countries : Overview

1. Motivation2. Theory – Pricing Along a Distribution Chain3. Estimation technique – VAR with block restrictions4. Results

Croatia Other CEE countries

5. “Natural experiment” 6. Conclusion

1. Motivation – understand the impact of exchange rate on prices in Croatia

The CNB relies on the stable (managed) exchange rate to euro as a nominal anchor

Very small oscilations of EUR/HRK; not large enough to influence prices (menu costs) which prevents empirically testing pass-trough

Large variability of USD/EUR is reflected in USD/HRK and effective exchange rate

=> we hope to use this volatility to improve our understanding of the impact of exchange rate on prices

Indices of daily nominal exchange rates of kuna vs. EUR and USD

(2001 = 100)

60

70

80

90

100

110

120

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

HRK/EUR HRK/USD

1. Motivation (cont.) – empirical finding: strong correlation between inflation and EUR/USD in

Croatia…

EUR/USD exchange rate (annual changes) and Croatia’s annual CPI inflation (normalized)

-3

-2

-1

0

1

2

3

1999 2000 2001 2002 2003 2004 2005 2006 2007

CPI Croatia EUR/USD

1. Motivation (cont.) – … and also in other CEECs

EUR/USD exchange rate (annual change) and the principal component of 7 CEEC annual inflation rates (normalized)

-3

-2

-1

0

1

2

3

1999 2000 2001 2002 2003 2004 2005 2006

CEEC's diffusion index EUR\USD

Why USD/EUR?

1. Most CEECs “manage” their exchange rate to EUR => USD/LC ~ USD/EUR, i.e. exogenous

• Effective exchange rate also largely exogenous (larger weight of EUR, but higher volatility of the USD dominates)

2. Significant share of imports priced in USD (mostly commodities (oil), but also manufactured goods (Asia))

=> influences prices of imported good

3. USD/EUR contains many information • (high correlation with interest rates, foreign demand, etc.)

4. External forecasts / futures market data available

2. The model of pricing along the distribution chain

COMMODITIES AND IMPORTED GOODS + USD/EUR

+EUR/LOCAL CURRENCY

▼IMPORT PRICES

▼PRODUCER PRICES

▼CONSUMER PRICES

3. Estimation technique – VAR with block restrictions

important to differentiate external and domestic variables/shocks – domestic should not influence external

Foreign block : commodity prices and USD/EUR Domestic block : output gap, (EUR/LC), PPI, CPI

Data

IFS, 1999 – 2006, quarterly frequency 2 lag VAR, specified in dlog’s 7 countries

3 exchange rate targeters: Bulgaria, Croatia, Estonia 4 inflation targeters: Czech R, Hungary, Poland, Slovak R

Latvia, Lithuania, Romania and Slovenia excluded due to significant regime change

4. Results: Croatia

Previous studies concentrated on Croatia not successful in finding the exchange rate pass-trough included the CNB’s policy rate : EUR/HRK

Cross country studies of pass-through (USD/HRK, NEER) “conclusion of low pass-trough in Croatia” ?!

Our VAR specification: external block: WCP, USD/EUR internal block: output gap, PPI, CPI (import prices not available for Croatia; EUR/HRK not

important)

Variance decomposition for Croatia external shocks dominate, especially USD/EUR strongest on the CPI

• combination of WPC and USD/EUR explains lower share of the CPI variance than sum of variables expressed separately

• other VAR specification (including with EUR/HRK) don’t influence our findings

Croatia: VAR impulse responses Output gap's response to WPI

5 10 15 20

-0.0

10

0.0

00

0.0

10

Output gap's response to USD/EUR

5 10 15 20

0.0

00

0.0

10

0.0

20

PPI's response to WPI

5 10 15 20

0.0

00

0.0

10

0.0

20

0.0

30

PPI's response to USD/EUR

5 10 15 20

-0.0

20

-0.0

10

0.0

00

CPI's response to WPI

5 10 15 20

0.0

00

0.0

04

0.0

08

CPI's response to USD/EUR

5 10 15 20

-0.0

10

-0.0

06

-0.0

02

Croatia: evidence from microdata supports our finding

correlation of individual CPI components with the USD/EUR exchange rate

strong correlations for goods mostly manufactured in Asia household appliances (-0.73) glassware and tableware utensils (-0,69) clocks, watches and jewelry (-0,59) toys (-0,59) footwear (-0,52) garments (-0,50)

and goods & services with a large share of oil in its cost structure

passenger transport by road (-0,65) fuels and lubricants for personal transport equipment (-0,64) air-transport (-0,54)

on the other hand, most of the (non-travel) services, food and other non-tradables not correlated with USD/EUR

Results CEECs : CPI variance decomposition

high impact of USD/EUR for the exchange rate targeters, but weaker for the inflation targeters

CEECs: CPI’s response on one unit residual shock

5. “Natural Experiment”

Lithuania changed its peg from USD to EUR in February 2002 Correlation USD/EUR to inflation changed from 0.46 to -0.69 Lithuania “missed” the Maastricht inflation criterium by 0.05%

5. “Natural Experiment”

Lithuania changed its peg from USD to EUR in February 2002 Correlation USD/EUR to inflation changed from -0.46 to 0.69 Lithuania “missed” the Maastricht inflation criterium by 0.05%

-3

-2

-1

0

1

2

3

1999 2000 2001 2002 2003 2004 2005 2006

Lithuania CPI EUR/USD

Conclusions

We find that in countries with stable exchange rate to euro, fluctuations of USD/EUR exchange rate might be one of the leading factors responsible for inflation variation this can be described as the success of existing policies in

achieving low inflation, but also exposes a danger / difficulty of coping with the external shocks

Especially important during the run-up to the eurozone in case of dollar appreciation those countries might need to

use other economic policies (instead of the monetary policy) for containing effects of temporary shock

1.5% buffer in the Maastricht criteria might not be enough to accommodate rising inflation in the case of larger dollar appreciation

Possible to use USD/EUR for forecasting/explaining inflation

Thank you for your comments !