The exchange rate-consumer price puzzle

Since February of 2002, the dollar has lost 27% of its value relative to other major currencies. Over the same period, consumer prices (excluding food and energy goods) have increased by a much smaller amount--8.9%. To economists, and particularly to central bankers and others who think about forecasting inflation, this relative insensitivity of consumer prices to exchange rates is a puzzle; indeed, it is one that has a long history and that is a characteristic not only of the U.S. but of other countries as well. ; Why is it a puzzle? Because international trade theory argues that, if all goods and services were traded at a negligible cost and if their prices reflected only their production costs, then retail prices should be very responsive to exchange rate changes. ; Of course, one might expect that the solution to the puzzle is in part related to the distances and costs involved in shipping goods, as that would clearly imply that trading costs are not negligible. But recent research suggests that other factors are better at explaining not only why consumer prices are relatively insensitive to exchange rate movements but also why they are even less sensitive than import prices. One explanation rests on the inclusion of non-traded good and service costs as part of the consumer price index (CPI). While import prices may respond to exchange rate changes, consumer prices, which include many non-traded cost components, may not. A second explanation arises from the profit margins that foreign exporters and local distributors have as a result of imperfect competition. Exporters and distributors may choose to adjust their profit margins rather than change price levels in response to exchange rate changes, for example, to maintain market share. ; This Economic Letter first reviews the empirical evidence on exchange rates, import prices, and consumer prices. It then discusses recent studies that evaluate alternative theories to explain the puzzle.