Has the pass-through of movements in the euro exchange rate into import prices changed since the start of EMU?

The degree of exchange rate pass-through into an economy’s domestic prices is an important area of analysis from the standpoint of a price stability-geared monetary policy. High passthrough rates of exchange rate changes into import prices, and from these to final costs in the economy, mean that nominal exchange rate fluctuations can give rise to significant changes in the relative prices of goods and in the level of inflation. Unsurprisingly, this issue has been subject to continuous analysis since, in the early seventies, the Bretton Woods exchange regime broke down and exchange rates in the Western economies were allowed to float. Since then, analysis of the determinants of the degree of pass-through has addressed both the relative significance of the macroeconomic determinants – such as the behaviour of inflation – and more microeconomic aspects, which highlight the importance of the structure of import markets and, in particular, of the degree of competition they display. An earlier paper [Campa and González Mínguez (2002)] estimated the rates of exchange rate pass-through into import prices and final prices in euro in the euro area countries. The main conclusions drawn from this analysis were that, in the short term, the pass-through to import prices is incomplete and varies significantly depending on the type of product imported and on the country of destination, tending to be higher for commodities. In the long run, however, it could not be rejected that for the industries examined the exchange rate pass-through rates to import prices were 100% and the same across the different countries. It was also seen that the main determinant of the differences between euro area countries regarding the overall impact of exchange rate movements on final consumer prices and on input costs was the different degree of openness of each economy. Indeed, this factor prevailed over differences arising from the product composition of imports in the face of different estimated pass-through rates for each industry. The foregoing paper used a monthly data set ending in March 2001. The shortage of observations subsequent to the start of EMU prevented any evaluation of the extent to which the single currency might have marked a structural change in the pass-through of exchange rate movements to import prices in the euro area. The enlargement of the sample with the latest data should allow sounder conclusions to be drawn about the possible existence of such a structural change, which is the main purpose of this article, whose sample period concludes in May 2004. There are three main reasons why the elasticity of pass-through might be expected to have diminished following the inception of the euro. Firstly, the process of monetary union has entailed a certain convergence of the member countries’ average inflation rates towards the levels of those economies where such rates have traditionally been lower. Since the higher inflation tradition of a country has been associated in the literature with higher pass-through rates, these have foreseeably declined in a large number of members. Secondly, there are arguments suggesting that the creation of EMU may have encouraged intra-area trade at the expense of trade with the rest of the world. Were this confirmed, it might have led to a lesser pass-through into import prices (via the relative reduction in the market power of exporters outside the euro area) and to final prices (since the proportion of final demand in the area met by non-euro area imports would have fallen). Thirdly and finally, it has been argued that the exchange rate pass-through to prices is smaller the greater the percentage of imports denominated in local currency. Insofar as the creation of a large monetary zone, such as the euro area, has promoted the expansion of the euro as a currency of denomination for its foreign trade, the rates of pass-through to import prices would have tended to diminish. The following section analyses these three arguments whereby the inception of EMU may have reduced the pass-through rates of the euro area countries, placing particular emphasis on the last two arguments. To do this, changes in the degree of exposure to imports from outside the area are studied and developments in the use of the euro as a reference currency for setting import and export prices within the euro area are analysed. The conceptual consequences such use entails for the degree of pass-through of exchange rate movements to import prices are also studied. After this, the presence of changes in pass-through rates to import prices since the introduction of the euro is empirically studied. The third section shows the methodological framework used to this end, while the fourth presents the main findings and evaluates the extent to which there is evidence of a structural change in the transmission of exchange rate movements to domestic prices. The final section draws the conclusions.