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

1. The Impact of the USD/EUR Exchange Rate on Inflation in CEE Countries Ljubinko Jankov, Ivo Krznar, Davor Kunovac, Maroje Lang

3. The Impact of the USD/EUR Exchange Rate on Inflation in CEE Countries: Overview • Motivation • Theory – Pricing Along a Distribution Chain • Estimation technique – VAR with block restrictions • Results • Croatia • Other CEE countries • “Natural experiment” • Conclusion

4. 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

5. 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)

6. 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)

7. Why USD/EUR? • 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) • Significant share of imports priced in USD (mostly commodities (oil), but also manufactured goods (Asia)) => influences prices of imported good • USD/EUR contains many information • (high correlation with interest rates, foreign demand, etc.) • External forecasts / futures market data available

8. 2. The model of pricing along the distribution chain COMMODITIES AND IMPORTED GOODS + USD/EUR + EUR/LOCAL CURRENCY ▼ IMPORT PRICES ▼ PRODUCER PRICES ▼ CONSUMER PRICES

9. 3. Estimation technique – VAR with block restrictions • important to differentiate externaland domestic variables/shocks – domestic should not influence external • Foreign block : commodity prices and USD/EUR • Domestic block : output gap, (EUR/LC), PPI, CPI

10. 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

11. 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)

12. 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

13. Croatia: VAR impulse responses

14. 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

15. Results CEECs :CPI variance decomposition • high impact of USD/EUR for the exchange rate targeters, but weaker for the inflation targeters

16. CEECs: CPI’s response on one unit residual shock

17. 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%

18. 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%

19. 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

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