The Bank for International Settlements (BIS) published a study finding that countries with weaker fiscal health experience higher exchange rate pass-through to inflation. The research, titled 'What Determines Exchange Rate Pass-Through: Empirical Analysis Using Nonparametric Methods,' analyzed data from 98 countries over 40 years. BIS identified this as the first study to establish a direct link between fiscal soundness and the degree to which currency depreciation translates into price increases. The findings suggest that maintaining both price stability and fiscal discipline is necessary to limit inflation pressure from exchange rate movements.
BIS Study Analyzes 98 Countries Over 40-Year Period
The BIS paper examined factors determining exchange rate pass-through and the relative contribution of each factor using a dataset spanning 98 countries over four decades. The study employed nonparametric methods to assess how currency fluctuations affect domestic prices. BIS found that exchange rate changes typically transmit to prices within the same quarter or the following quarter, indicating rapid pass-through speed.
Fiscal Deficit Above 5% GDP Raises Pass-Through to 35%
The research identified fiscal health as a key determinant of pass-through rates. When fiscal deficits exceeded 5% of GDP, the pass-through rate reached 35%. In contrast, countries with fiscal surpluses of 5% of GDP experienced a pass-through rate of only 17%. BIS explained that markets perceive governments with expanding deficits as likely to tolerate inflation to stabilize real debt values when they fail to credibly commit to future fiscal consolidation. BIS stated this paper is the first to provide evidence linking exchange rate pass-through to national fiscal soundness.
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Inflation Above 5% Doubles Currency Depreciation Impact
Inflation levels emerged as another critical variable. Low average inflation suppressed exchange rate transmission to prices, but pass-through rates increased noticeably once inflation exceeded 5%. BIS reported that pass-through rates at 20% inflation were approximately double those at 2% inflation. The findings indicate that maintaining low average inflation correlates with keeping pass-through rates at moderate levels.
Exchange Rate Volatility Shows U-Shaped Relationship
Exchange rate volatility exhibited a U-shaped relationship with pass-through rates. Pass-through was highest when volatility was either extremely low or extremely high, and lowest at intermediate volatility levels. BIS attributed this pattern to price-setters adopting a wait-and-see approach to price adjustments when volatility is moderate. The study also found that smaller economies tend to experience higher pass-through rates.
BIS Recommends Balanced Monetary and Fiscal Policy
The research implies that central banks must manage prices stably while governments maintain sound fiscal operations to control the extent to which exchange rate fluctuations create additional inflation pressure. BIS assessed that policies either artificially suppressing exchange rate volatility or allowing it to run unchecked both risk raising pass-through rates and are therefore undesirable.
FAQ
What did the BIS study find about fiscal deficits and inflation?
The BIS study found that countries with fiscal deficits exceeding 5% of GDP experienced a 35% exchange rate pass-through to inflation, while countries with 5% fiscal surpluses saw only a 17% pass-through rate.
How does inflation level affect exchange rate pass-through?
BIS reported that pass-through rates remain low when average inflation is low, but increase significantly once inflation exceeds 5%. At 20% inflation, pass-through rates are approximately double those at 2% inflation.
Why does exchange rate volatility show a U-shaped relationship with pass-through?
BIS explained that pass-through is highest at extremely low or high volatility levels and lowest at intermediate levels because price-setters delay price adjustments when volatility is moderate, adopting a wait-and-see approach.
