Exchange-rate pass-through to the consumer price index: a microeconomic approach

24.10.2006

Exchange-rate pass-through to the consumer price index: a microeconomic approach

The views expressed in this paper are those of the author alone, and do not necessarily reflect those of the Bank of Israel.

	The coefficient of the pass-through from the dollar exchange rate to the consumer price index (CPI) is about 29 percent. A decline in the coefficient has been evident in the last few years, attributable to the stability of the exchange rate and the reduction of inflation.
	The housing component of the index accounts for about half of the pass-through, due to the widespread dollarization in the housing market.
	The indexation of prices to the exchange rate, such as the mechanisms for determining fuel and electricity prices, also affect the pass-through in other CPI components.
	The effect of aggregate demand on the pass-through was not found to be significant.
The pass-through from the exchange rate to inflation is an important macroeconomic concept, and it constituted one of the major constraints on monetary policy in Israel in the last few years, and strongly influences monetary policy decisions. Several studies conducted in Israel during the last few years have produced estimates of the pass-through.
A new research paper written by Yoav Soffer of the Bank of Israel Foreign Exchange Activity Department estimates the pass-through using an approach not previously employed in Israel. This approach breaks the CPI down into 31 components, in an attempt to identify the sources of the pass-through. In addition to the standard division of the index into major groups, a distinction is made between tradable and nontradable goods, and between price-controlled or price-supervised goods and services and those which are not, in order to examine the extent to which price supervision affects the pass-through. The equations are estimated using data from the years 1991 to 2004, and employ other variables, apart from the exchange rate, to which variation in the various components of the CPI could be attributed.
The main finding of the research is that the pass-through from the dollar exchange rate to the CPI is about 29 percent, a result that is consistent with the findings of earlier studies on the subject. Most of the pass-through is immediate, and takes place within the quarter in which the exchange rate change is recorded. The state of aggregate demand was found not to have a significant effect on the pass-through; in other words, there was no significant difference between the pass-through coefficient in a recession and in a boom. On the other hand, the stabilization of the exchange rate and the reduction of inflation to low rates in the last few years resulted in a lower pass-through in the years 1999–2004 (24 percent) than in the years 1991–1998 (33 percent).
The main contribution of the current study lies in its locating the sources of the pass-through: thus, it was found that about half of the total pass-through derives from the housing component, in which the pass-through is about 70 percent, and after weighting by the weight of this component in the overall CPI, this item contributes 15 percentage points to the total pass-through. This result is due to the widespread dollarization in the housing market: about 90 percent of rental contracts are indexed to the dollar exchange rate, despite the fact that housing services are unmistakably a nontradable item, with no theoretical reason for any connection between domestic prices and the exchange rate. This dollarization was a natural outcome of Israel’s inflationary history, which is still reflected in the conduct of individuals. A change in the behavior pattern in the housing industry could thus make a marked contribution to the reduction of the pass-through. The fact that prices of owner-occupied housing services are calculated by the Central Bureau of Statistics using the same sample of rental contracts as is used for the rent component of the CPI also amplifies the effect of the exchange rate on the total housing component.
Various indexation mechanisms reinforce the pass-through from the exchange rate to the CPI in other components too. For example, indexation arrangements governing electricity prices lead to a relatively high pass-through also in that industry. Likewise, the mechanism for determining ex refinery fuel prices, which are updated monthly according to changes in world prices and in the exchange rate, boost the pass-through in this category. In contrast, certain components which do not have mechanisms or norms of indexation to the exchange rate are noteworthy: car prices, for example, have a low pass-through, and in the clothing and footwear component no pass-through from the exchange rate to domestic prices was found.

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