The Impact of the USD/EUR Exchange Rate on Inflation in CEE Countries Ljubinko Jankov, Ivo Krznar, Davor Kunovac, Maroje Lang

The Impact of the USD/EUR Exchange Rate on Inflation in CEE Countries : Overview 1. Motivation 2. Theory – Pricing Along a Distribution Chain 3. Estimation technique – VAR with block restrictions 4. Results  Croatia  Other CEE countries 5. “Natural experiment” 6. Conclusion

1. Motivation – understand the impact of exchange rate on prices in Croatia  The CNB relies on the stable (managed) exchange rate to euro as a nominal anchor  Very small oscilations of EUR/HRK; not large enough to influence prices (menu costs) which prevents empirically testing pass-trough  Large variability of USD/EUR is reflected in USD/HRK and effective exchange rate => we hope to use this volatility to improve our understanding of the impact of exchange rate on prices

1. Motivation (cont.) – empirical finding: strong correlation between inflation and EUR/USD in Croatia… EUR/USD exchange rate (annual changes) and Croatia’s annual CPI inflation (normalized)

1. Motivation (cont.) – … and also in other CEECs EUR/USD exchange rate (annual change) and the principal component of 7 CEEC annual inflation rates (normalized)

Why USD/EUR? 1. Most CEECs “manage” their exchange rate to EUR => USD/LC ~ USD/EUR, i.e. exogenous Effective exchange rate also largely exogenous (larger weight of EUR, but higher volatility of the USD dominates) 2. Significant share of imports priced in USD (mostly commodities (oil), but also manufactured goods (Asia)) => influences prices of imported good 3. USD/EUR contains many information (high correlation with interest rates, foreign demand, etc.) 4. External forecasts / futures market data available

2. The model of pricing along the distribution chain COMMODITIES AND IMPORTED GOODS + USD/EUR + EUR/LOCAL CURRENCY ▼ IMPORT PRICES ▼ PRODUCER PRICES ▼ CONSUMER PRICES

3. Estimation technique – VAR with block restrictions  important to differentiate external and domestic variables/shocks – domestic should not influence external  Foreign block : commodity prices and USD/EUR  Domestic block : output gap, (EUR/LC), PPI, CPI

Data  IFS, 1999 – 2006, quarterly frequency  2 lag VAR, specified in dlog’s  7 countries 3 exchange rate targeters: Bulgaria, Croatia, Estonia 4 inflation targeters: Czech R, Hungary, Poland, Slovak R  Latvia, Lithuania, Romania and Slovenia excluded due to significant regime change

4. Results: Croatia  Previous studies concentrated on Croatia not successful in finding the exchange rate pass-trough included the CNB’s policy rate : EUR/HRK  Cross country studies of pass-through ( USD/HRK, NEER ) “conclusion of low pass-trough in Croatia” ?!  Our VAR specification: external block: WCP, USD/EUR internal block: output gap, PPI, CPI (import prices not available for Croatia; EUR/HRK not important)

Variance decomposition for Croatia  external shocks dominate, especially USD/EUR  strongest on the CPI combination of WPC and USD/EUR explains lower share of the CPI variance than sum of variables expressed separately other VAR specification (including with EUR/HRK) don’t influence our findings

Croatia: VAR impulse responses

Croatia: evidence from microdata supports our finding  correlation of individual CPI components with the USD/EUR exchange rate  strong correlations for goods mostly manufactured in Asia  household appliances (-0.73)  glassware and tableware utensils (-0,69)  clocks, watches and jewelry (-0,59)  toys (-0,59)  footwear (-0,52)  garments (-0,50) and goods & services with a large share of oil in its cost structure  passenger transport by road (-0,65)  fuels and lubricants for personal transport equipment (-0,64)  air-transport (-0,54)  on the other hand, most of the (non-travel) services, food and other non- tradables not correlated with USD/EUR

Results CEECs : CPI variance decomposition  high impact of USD/EUR for the exchange rate targeters, but weaker for the inflation targeters

CEECs: CPI’s response on one unit residual shock

5. “Natural Experiment”  Lithuania changed its peg from USD to EUR in February 2002  Correlation USD/EUR to inflation changed from 0.46 to  Lithuania “missed” the Maastricht inflation criterium by 0.05%

5. “Natural Experiment”  Lithuania changed its peg from USD to EUR in February 2002  Correlation USD/EUR to inflation changed from to 0.69  Lithuania “missed” the Maastricht inflation criterium by 0.05%

Conclusions  We find that in countries with stable exchange rate to euro, fluctuations of USD/EUR exchange rate might be one of the leading factors responsible for inflation variation this can be described as the success of existing policies in achieving low inflation, but also exposes a danger / difficulty of coping with the external shocks  Especially important during the run-up to the eurozone in case of dollar appreciation those countries might need to use other economic policies (instead of the monetary policy) for containing effects of temporary shock 1.5% buffer in the Maastricht criteria might not be enough to accommodate rising inflation in the case of larger dollar appreciation  Possible to use USD/EUR for forecasting/explaining inflation

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