The transmission of exchange rate changes to euro area inflation

Aggregate exchange rate pass-through (ERPT) to import and consumer prices is lower in the EU than it was in the 1990s and is found to be non-linear. Low estimated aggregate ERPT to consumer prices does not mean that the exchange rate movements do not matter for inflation, as aggregate estimates mask substantial heterogeneities across countries, industries and time periods due to structural, cyclical and policy factors. Key structural characteristics that explain ERPT across industries or sectors are: import content of consumption; share of imports invoiced in own currency or in a third dominant currency; integration of a country and its trading partners in global value chains; and market power. In line with the literature, different types of shocks that move the exchange rate in the euro area elicit different price responses, so the combination of shocks that lie behind changes in the exchange rate at any point in time matters for the ERPT. Finally, monetary policy itself affects the ERPT and credible and active monetary policy lowers the observed ex post ERPT. Moreover, under the effective lower bound, credible non-standard monetary policy actions have a larger ERPT to consumer prices. Instead of rules of thumb, in order to assess the impact of exchange rate changes when forecasting inflation, it is better to use structural models with sufficient feedback loops that take into account the role of expectations and monetary policy reaction. JEL Classification: E31, F31, F41