Blog Post

The exchange rate and inflation in the euro-area: words following facts

The reduced references in the speeches of the President and Vice-president of the ECB to exchange rate changes in assessing inflation developments correspond to a decreased pass-through from the exchange rate to inflation. So, as it should be, words have followed facts

By: Date: February 16, 2018 Topic: European Macroeconomics & Governance

Some observers have been quite surprised by the repeated, unusually pointed, reaction of ECB President Draghi in his January Press Conference to the exchange rate statement of US Treasury Secretary Mnuchin, according to whom: “Obviously a weaker dollar is good for us as it relates to trade and opportunities”.

The term “exchange rate” was mentioned 28 times in the question-and-answer session of the ECB Press Conference and some of the statements made by Mario Draghi clearly expressed irritation, which must have, in turn, reflected irritation voiced in the Governing Council meeting. For instance Draghi said: “Finally, … there is a third reason [for exchange rate volatility] which [is] … the use of language being discussed in exchange rate developments, that doesn’t reflect the terms of reference that have been agreed lastly on October 14, 2017 in the IMFC in Washington.”  And then he added:  “… The exchange rate has moved in part … for exogenous reasons that have to do with communication, but not by the ECB, but by someone else. This communication, not the ECB communication, but someone else’s communication, doesn’t comply with the agreed terms of references; ….”

This insistence on the exchange rate is even more clearly a sign of irritation towards the Mnuchin statement if one recalls the long-term trend, which I documented in a post published on October 25, 2017. The ECB, based on quotations from speeches of the president and vice-president, has moved, in its understanding of inflation, from a small-country model in which the pass-through of exchange-rate movements to inflation is the dominant force, to a large-country model in which conditions in the labour market, as conceptualised by the Phillips curve, have more importance. With this change, the ECB got somewhat closer to the Fed approach to understanding inflation, in which conditions in the labour market have always been prevalent.sed on the evidence displayed in Figure 1 (in particular looking at the red line), I wrote: “One should conclude that, about a decade after the adoption of the euro, the ECB moved from the paradigm of a small, open economy towards that of a large economy.  This change of perspective would have happened during Trichet’s tenure. Thus, since more than 10 years, the ECB clearly gives less weight than previously to the exchange rate and other variables consistent with the small-country approach in assessing inflation prospects.”

I expect that a similar exercise conducted over papers prepared in Eurosystem central banks would show an equally clear move away from studies concentrating on the exchange rate to studies looking at domestic determinants of inflation.

In the post mentioned above, I just documented the change but did not really give a possible reason for it. In principle one can think of a number of non-exclusive, reasons for the change:

  • The first possible reason could be intellectual inertia; it just took time to understand that, with the euro, one had to move away from a small country to a large country model.
  • The second possible reason, partially overlapping with the first, would consider psychology. The first ECB President, Wim Duisenberg, came from the Netherlands – a country that had as its only monetary guide keeping the exchange rate of the guilder stable towards the deutschemark. The second ECB President, Jean-Claude Trichet, under whom the move towards the large-country model took place, came from France, a larger country than the Netherlands, where domestic developments were more important for inflation.
  • The third possible reason is of a more general nature. The euro was, and somehow still is, an unprecedented experiment and the euro exchange rate was, in a way, a sign of the success of the experiment, thus an emphasis on it was justified beyond its importance for monetary policy.

These three reasons are plausible but cannot be easily tested. I have however now found, in a speech by B. Coeure[1], a possible objective explanation for the trend decrease of the ratio between the frequency of terms consistent with the small-country model and the frequency of terms consistent with the large-country model that I documented in my post: the progressive decline in the pass-through of exchange-rate changes to inflation.

Figure 1. Exchange rate pass-through to HICP-inflation and ratio of frequency of terms consistent with the small and the large country approach.

Source: Authors elaboration, and Cœuré (2017).

Notes: The red line is the ratio between the frequency of terms consistent with the “small” country model and the frequency “large” country model. The blue line is the cumulated impulse response of HICP inflation to a 1% appreciation in the NEER after three years. It is based on the updated estimation of Hahn (2003) over a 20-year rolling window from the first quarter of 1980 to the first quarter of 2016. Each point on the blue line refers to the end of each 20-year rolling sample, with the first sample referring to the period from the second quarter of 1981 to the first quarter of 2000 and the last sample to the period from the second quarter of 1996 to the first quarter of 2016.  The scale has been inverted. The underlying data of the pass-through as well as the above description have been kindly provided by the ECB.

 I don’t want to make too much of the common trend of the two curves appearing in Figure 1, but it is certainly suggestive that the decrease in the weight given by the ECB to the exchange rate (and other variables consistent with the small-country model) in understanding inflation has coincided with a withering of the effect of exchange-rate changes on inflation. So, there may be objective, structural reasons for the change in perspective rather than intellectual inertia or other, less verifiable reasons.

To check this hypothesis I ran a regression in which the relative frequency of  “small country” to “ large country” terms is explained by the structural decrease in the exchange pass-through as estimated in the Coeure speech. The results of this regression are presented in Table 1.

A possible interpretation of the regression results is that the decreasing importance attributed by the ECB to small-country variables in understanding inflation is explained by the reduced effect of exchange-rate changes on inflation. So, changing words seem to be determined by changing facts.

The policy conclusions of my previous post get somewhat reinforced by the reading offered here: the decrease in the weight of the exchange rate in assessing inflation developments is grounded in changing structural factors; thus, an exchange-rate appreciation should have less of an effect in deterring the ECB from reducing the ease in its monetary policy.

Still, the strong reaction to the Mnuchin statement shows that the ECB is well alert to the risks of competitive devaluations. And the risks are not only for the control of inflation and activity in the euro area: the damages of beggar-thy-neighbour policies for the world economy, especially when played by large, globally relevant countries such as the US and the euro-area, are too well documented to take a relaxed attitude to their manifestations. It is somewhat discomforting that this fact does not seem to be well understood by the Trump administration.

 

This post was prepared with the assistance of Alessandra Marcelletti.

[1] The transmission of the ECB’s monetary policy in standard and non-standard times

Speech by Benoît Cœuré, Member of the Executive Board of the ECB, at the workshop “Monetary policy in non-standard times”, Frankfurt am Main, 11 September 2017.

 


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Blog Post

Croatia’s path into the banking union

Croatia seems a suitable candidate for euro area accession: there is a tight peg to the euro, high public debt is coming down, and the banking sector is already dominated by euro area banks. But the Eurogroup has rightly targeted reforms of the state’s role in the economy as a precondition for participation in ERM II and the banking union. None of the announced reform plans are new or easily concluded within the timeframe that has now been agreed.

By: Alexander Lehmann Topic: European Macroeconomics & Governance Date: July 18, 2019
Read article More on this topic

Blog Post

‘Lo spread’: The collateral damage of Italy’s confrontation with the EU

The authors assess whether the European Commission's actions towards Italy since September 2018 have had a visible impact on the spread between Italian sovereign-bond yields and those of Germany, and particularly whether the Commission’s warnings have acted as a ‘signalling device’ for bond-market participants that it might be difficult for Italy to obtain the support of the ESM or the ECB’s OMT programme if needed.

By: Grégory Claeys and Jan Mazza Topic: European Macroeconomics & Governance Date: July 8, 2019
Read article More on this topic More by this author

Podcast

Podcast

Director's Cut: Priorities for the new ECB president

In this Director's Cut of 'The Sound of Economics', Guntram Wolff talks to two of the authors of Bruegel's memo to the new ECB president, Maria Demertzis and Grégory Claeys, to specify the most important issues at the beginning of this eight-year cycle and to clarify the parameters within which the new incumbent will have to work.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: July 4, 2019
Read article Download PDF More on this topic

Policy Brief

Preparing for uncertainty

Memo to the president of the European Central Bank. Grégory Claeys, Maria Demertzis and Francesco Papadia present the challenges that the next ECB president will face during the upcoming mandate, reinventing monetary policy in a system riddled with uncertainties.

By: Grégory Claeys, Maria Demertzis and Francesco Papadia Topic: European Macroeconomics & Governance Date: July 3, 2019
Read article More on this topic More by this author

Blog Post

The breakdown of the covered interest rate parity condition

A textbook condition of international finance breaks down. Economic research identifies the interplay between divergent monetary policies and new financial regulation as the source of the puzzle, and generates concerns about unintended consequences for financing conditions and financial stability.

By: Konstantinos Efstathiou Topic: Finance & Financial Regulation Date: July 1, 2019
Read about event

Upcoming Event

Sep
16
08:30

Climate change and the role of central banks

What connections exist between central banks and climate change, and what are the resulting implications?

Speakers: Emanuele Campiglio, Paul Hiebert, Pierre Monnin, Kjell G. Nyborg, Luiz Awazu Pereira da Silva, Mario Quagliariello, Mattia Romani, Paweł Samecki and Dirk Schoenmaker Topic: Energy & Climate, European Macroeconomics & Governance Location: Narodowy Bank Polski, Świętokrzyska 11/21, 00-919 Warsaw
Read article More on this topic More by this author

Podcast

Podcast

Director's Cut: ECB monetary policy decisions deconstructed

In this Director’s Cut, Bruegel’s Grégory Claeys and Maria Demertzis take a deeper look at whether the monetary policy decisions made by the ECB over the past three presidential eras arrived by consensus, by unanimity or by majority votes of the governing council.

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: June 27, 2019
Read article More on this topic

Blog Post

The evolution of the ECB governing council's decision-making

Before it is decided who will chair the governing council for the next eight years, the authors look back and examine precisely how decisions have been taken since the ECB was created – by unanimity, by majority, or by consensus.

By: Grégory Claeys and Tanja Linta Topic: European Macroeconomics & Governance Date: June 27, 2019
Read about event More on this topic

Past Event

Past Event

Sound at last? Assessing a decade of financial regulation

What has changed since the financial crisis of 2008 that makes the financial system sound at last? Is regulatory reform going in the right direction? Has it run its course? 

Speakers: Patrick Bolton, Rebecca Christie, Maria Demertzis, Mathias Dewatripont and Xavier Vives Topic: Finance & Financial Regulation Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: June 20, 2019
Read about event More on this topic

Past Event

Past Event

What reforms for Europe's Monetary Union: a view from Spain

How is a successful European Monetary Union still possible in today's ever-shifting political landscape? What reforms need to occur in order to guarantee success of cohesive policies?

Speakers: Fernando Fernández, José Carlos García de Quevedo, Gabriele Giudice, Inês Goncalves Raposo, Javier Méndez Llera and Isabel Riaño Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: June 19, 2019
Read article More on this topic More by this author

Blog Post

The inverted yield curve

Longer-term yields falling below shorter-term yields have historically preceded recessions. Last week, the US 10-year yield was 21 basis points below the 3-month yield, a feat last seen during the summer of 2007. Is the current yield curve a trustworthy barometer for future growth?

By: Inês Goncalves Raposo Topic: Global Economics & Governance Date: June 11, 2019
Read article More on this topic More by this author

Opinion

Too crowded bets on “7” for USDCNY could be dangerous

The Chinese yuan has been under pressure in recent days due to the slowing economy and, more importantly, the escalating trade war with the US. While the Peoples Bank of China has never said it will safeguard the dollar-yuan exchange rate against any particular level, many analysts have treated '7' as a magic number and heated debates have begun over whether the number is unbreakable.

By: Alicia García-Herrero Topic: Global Economics & Governance Date: June 6, 2019
Load more posts