Before we get into that a few words about price indexes will be useful.<\/p>\n
Most national statistical authorities publish a range of ‘price’ index measures. The Australian Bureau of Statistics, for example, publishes an Import Price Index within its – International Trade Price Indexes<\/a> – which were last published in December 2015.<\/p>\n Table 13.8<\/a> tells us that the Import Price Index (IPI):<\/p>\n \n… measures changes in prices of imports of merchandise into Australia. The index numbers for each quarter relate to prices of imports landed in Australia during the quarter.\n<\/p><\/blockquote>\n The ABS say that “All prices used in the IPI are expressed in Australian currency”. Why is that important?<\/p>\n The ABS say that:<\/p>\n \nAs a result, changes in the relative values of the Australian dollar and overseas currencies can have a direct impact on price movements of imports that are purchased in foreign currencies. Prices reported in a foreign currency are converted to Australian dollars using the relevant exchange rates at the date of change of ownership. Where foreign currency purchase prices use forward exchange cover, the prices used in the index exclude the forward exchange cover.\n<\/p><\/blockquote>\n The Consumer Price Index (CPI) is the best-known domestic measure of inflation although central banks typically use modified measures of the CPI to estimate so-called ‘core’ or ‘underlying’ inflation. This usually involves taking out volatile components such as energy prices and\/or trimming outlier observations.<\/p>\n According to the ABS Information Paper (6461.0) – Consumer Price Index: Concepts, Sources and Methods<\/a>:<\/p>\n \nThe CPI is a current social and economic indicator that is constructed to measure changes over time in the general level of prices of consumer goods and services that households acquire, use or pay for consumption. The index aims to measure the change in consumer prices over time. This may be done by measuring the cost of purchasing a fixed basket of consumer goods and services of constant quality and similar characteristics, with the products in the basket being selected to be representative of households’ expenditure during a year or other specified period.\n<\/p><\/blockquote>\n The point is that it is the prices of final goods and services that are computed in the CPI.<\/p>\n This definition is internationally accepted and was resolved at the Seventeenth International Conference of Labour Statisticians convened by the International Labour Organization (ILO) in 2003.<\/p>\n I won’t go into how the CPI is constructed here. That is a lifetime of writing in itself. The cited Information Paper is good reading though if you like technical detail. It is also applicable to most advanced nations at least although terminology might vary from country to country.<\/p>\n The impact of import prices on the CPI is, in part, determined by the proportion of total goods and services that are indeed imported and included in the CPI ‘basket’ of goods and services.<\/p>\n Further, the the weight of these classes of goods and services in the basket that comprises the CPI is clearly important.<\/p>\n The ABS have recently began publishing its “International trade exposure series”, which nets out the impact of ‘tradables’ and ‘non-tradables’ on the CPI.<\/p>\n The ‘Tradables component’:<\/p>\n \nComprises all items whose prices are largely determined on the world market.\n<\/p><\/blockquote>\n The latest – CPI Analytical Series<\/a> – estimates that the tradables component adds about 39.8 per cent to the variation in the CPI, the remainder being the non-tradables component.<\/p>\n The ERPT effect also depends on other factors including:<\/p>\n What is the evidence?<\/p>\n Consider the following graph, which shows the annual percentage change in the Australian-USD exchange rate from the September-quarter 1982 to the December-quarter 2015 (in blue columns) and the quarterly change (red line).<\/p>\n By any standards, the parity fluctuates a lot. In June 2001 it was down to 50.9 US cents per Australian dollar. Three years later it was up to 75 US cents. Then above parity a few years after that only to be back to 72 US cents in December 2015.<\/p>\n Australia is a very wealthy, high income nation which undergoes regular and large variations in our exchange rate. It is a good test case for ERPT.<\/p>\n Consider the following graph which shows the relationship between quarterly percentage fluctuations in the Australian-USD exchange rate (rising rate is an appreciation) and the quarterly changes in the CPI.<\/p>\n I have created three CPI series – the current value (blue), lagged by 12 months (red) and lagged by 24 months (green). Some argue that the impact of exhange rate fluctuations take time to work their way through to the domestic price level. So the lags out 12 and 24 months should pick up the lagged effect if there is one.<\/p>\n The linear black lines are just simple regressions. If there was a strong relationship as described in the mainstream theories (and the textbooks) then we would expect the regression lines to be visibly sloping downwards and the relationship between the two pairs of time series to be statistically significant.<\/p>\n The data range is from the September-quarter 1982 to the December-quarter 2015. So there is enough time for these effects to be disclosed.<\/p>\n The upshot is that there is no discernible effect of percentage changes in the Australian dollar parity against the USD (as an example) and the percentage change in the CPI.<\/p>\n I constructed the same graph for just the tradable component of the CPI and a similar result was derived.<\/p>\n Just for fun, I also constructed some quite complicated dynamic time series regression models (with all the tricks) to test higher and intermediate order lag effects controlled with other factors (such as domestic growth rates) and still found no significant relationship at any lag.<\/p>\n Conclusion: percentage shifts in the AUD\/US exchange rate (quarterly or annually) do not seem to have a significant impact on the Australian CPI or sub-measures of the CPI.<\/p>\n So why do we believe the conservatives when they claim that an exchange rate depreciation will impart dangerous inflationary forces into the domestic economy, which will undermine any attempts to use increased net public spending (that is, fiscal deficits) to reduce the unemployment rate back to full employment?<\/p>\n A huge empirical literature exists on this topic and it is a topic that central bank research department’s are particularly interested in, given the bias in monetary policy these days towards inflation control.<\/p>\n A Bank of Canada study – Has Exchange Rate Pass-Through Really Declined? Some Recent Insights from the Literature<\/a> – finds that:<\/p>\n \n…. the correlation between changes in consumer prices and changes in the nominal exchange rate has been quite low and declining over the past two decades for a broad group of countries …<\/p>\n there is fairly convincing evidence to suggest that measured short-term ERPT to consumer prices has declined …\n<\/p><\/blockquote>\n In relation to pass-through to import prices:<\/p>\n 1. The study suggests that the “decline in ERPT to import prices” is due “to increased trade integration, because supply chains have become more interconnected and globalized”.<\/p>\n This allows vertically-integrated multinational firms to shift production around natinos where currency movements are favourable.<\/p>\n Further, “large importers have significant market power, in particular, the power to discriminate between suppliers based on location” and mitigate any exchange rate impacts on import prices.<\/p>\n 2. The “swift and significant integration of emerging economies into global markets may have contributed to the fall in ERPT to import prices in many industrial countries by increasing the prevalence of pricing-to-market (PTM)”.<\/p>\n 3. “The decline in pass-through to aggregate import prices can therefore be attributed to changes in the underlying composition of products in each country’s import bundle, particularly the move away from commodities and towards products in sectors with higher degrees of product differentiation and lower degrees of ERPT, such as manufacturing”.<\/p>\n In relation to the pass-through to the CPI:<\/p>\n 1. “The large non-tradable component in distribution margins thus significantly insulates consumer prices from exchange rate movements” (Source<\/a>).<\/p>\n 2. “increased competition among retailers in the local market can also lead to a decline in ERPT to consumer prices”.<\/p>\n The Bank of Canada study also argues that:<\/p>\n \nthe expenditure-switching effect helps to redirect consumption and investment in a country with a trade deficit away from imports, as the exchange rate depreciates, making the country’s exports more attractive to foreigners … [thus] … The benefits of a flexible exchange rate may also be larger than they appear …\n<\/p><\/blockquote>\n A 2014 New Zealand central bank study – Exchange rate movements and consumer prices: some perspectives<\/a> – found that:<\/p>\n \nPetrol prices adjust substantially and quickly. But a significant share of New Zealand’s imports appear to be priced for the local market and, however they are priced, there is a large domestic distribution component for most tradable goods. That means prices for traded goods in New Zealand will adjust by a smaller percentage than any given percentage movement in the exchange rate, and may diverge from those in the rest of the world for protracted periods.\n<\/p><\/blockquote>\n A 2015 Bank of England paper – Much ado about something important: How do exchange rate movements affect inflation?<\/a> – provided three broad conclusions:<\/p>\n \nFirst, contrary to common belief, exchange rate movements don’t seem to consistently have larger effects on prices in sectors with a higher share of imported content. Second, exchange rates don’t seem to consistently have larger effects on prices in the most tradable and internationally-competitive sectors. Third, the effects of exchange rates on inflation – and even just on import prices – do not seem to be consistent across time. Most of what I learned in grad school on this topic no longer seems to apply.\n<\/p><\/blockquote>\n It argued that if we examine “what drives the initial exchange rate movement”, further insights can be gleaned.<\/p>\n So, for a supply-side shock will have different ERPT effects than in a situation where the exchange rate is depreciating at the same time a nation is experiencing “strong domestic demand” or “global demand”.<\/p>\n It says that when “exchange rate movements result primarily from changes in domestic and global demand, they are associated with very different inflation dynamics than other types of shocks – undoubtedly due to the support to company sales from stronger demand.”<\/p>\n This is one of those cases where economists in classrooms or in the media just sprout textbook mantras without any coherent understanding of the empirical content of their statements.<\/p>\n Sure enough we can draw complex diagrams that show conceptually how ERPT can work – with arrows going everywhere from this box to that box and so on – but there is a real world out there.<\/p>\n The real world tells us that the ERPT is weak in most nations for which coherent empirical research has been conducted.<\/p>\n There is some pass-through but not enough to trigger a hyperinflation and certainly not enough to derail a full employment program based on stimulating domestic demand.<\/p>\n Interestingly, the increased globalisation of supply chains and vertical integration of multinational firms has reduced each nations’ CPI response to exchange rate fluctuations.<\/p>\n So next time this issue is raised at your dinner table you know what to say!<\/p>\n This is a further part of a series I am writing as background to my next book on globalisation and the capacities of the nation-state. More instalments will come as the research process unfolds.<\/p>\n The series so far:<\/p>\n 1. Friday lay day – The Stability Pact didn’t mean much anyway, did it?<\/a><\/p>\n 2. European Left face a Dystopia of their own making<\/a><\/p>\n 3. The Eurozone Groupthink and Denial continues …<\/a> <\/p>\n 4. Mitterrand’s turn to austerity was an ideological choice not an inevitability<\/a><\/p>\n 5. The origins of the ‘leftist’ failure to oppose austerity<\/a><\/p>\n 6. The European Project is dead<\/a><\/p>\n 7. The Italian left should hang their heads in shame<\/a><\/p>\n 8. On the trail of inflation and the fears of the same …<\/a>.<\/p>\n 9. Globalisation and currency arrangements<\/a><\/p>\n 10. The co-option of government by transnational organisations<\/a><\/p>\n 11. The Modigliani controversy – the break with Keynesian thinking<\/a><\/p>\n\n
![\"Australia_AUD_USD_1982_2015\"](\"https:\/\/billmitchell.org\/blog\/wp-content\/uploads\/2016\/02\/Australia_AUD_USD_1982_2015.jpg\")
<\/a><\/p>\n![\"Australia_Chg_ER_Chg_CPI_1982_2015\"](\"https:\/\/billmitchell.org\/blog\/wp-content\/uploads\/2016\/02\/Australia_Chg_ER_Chg_CPI_1982_2015.jpg\")
<\/a><\/p>\nConclusion<\/h2>\n