Estimating exchange rate pass-through in New Zealand

Key findings

• This Note analyses exchange rate pass-through to tradables prices in each step of the transmission channel. Estimating the short-run and long-run impacts of movements in the exchange rate on import prices and tradables prices sheds light on its inflationary impacts. 
• Using a range of estimation methods, we find that a 1% appreciation in the Trade Weighted Index (TWI) for the New Zealand dollar exchange rate can lead to a 0.004 to 0.01% decline ex-fuel tradables prices within one quarter. In the long run, it can lead to a 0.05 to 0.3% decline in ex-fuel tradables prices. These estimates of incomplete pass-through are in line with estimates obtained for inflation-targeting economies in the related literature.  
• Asymmetries in exchange rate pass-through can arise in different economic environments and across time. For example, pass-through tends to be stronger when the output gap is materially positive than when it is materially negative. 

Why we did this research

The research in this Note is in line with our monetary policy research agenda theme of inflation. 

The exchange rate plays an important role in the determination of monetary policy in a small open economy. Generally, a central bank should be prepared to look through short-term inflation dynamics and focus on the medium-term impacts of exchange rate movements. These medium-term impacts can arise from channels such as higher cost pass-through and inflation expectations, should these movements become persistent. This Note aims to quantify pass-through from the NZD exchange rate to NZD import prices and then to tradables prices. 

Our analysis contributes to our current understanding of exchange rate pass-through. We distinguish between the immediate effects expected to occur in one quarter and the effects expected over a medium-term horizon that is relevant for setting monetary policy. The total effect of exchange rate movements on inflation are likely to be different from the estimates in this paper because of its transmission through economic activity.  

We find that our low estimates of exchange rate pass-through to consumer prices are in line with estimates obtained for inflation-targeting economies in the related literature. Even though pass-through from exchange rate fluctuations to import prices is high, import price volatility does not fully translate to movements in consumer (tradables) prices since different sources of price rigidities are more likely to arise at the latter stage. 

Further work using general equilibrium models is needed to assess the role of monetary policy in the dampening of exchange rate pass-through in recent years. While our Note only provides a partial equilibrium perspective, it still can be helpful to inform future monetary policy decisions on movements in the exchange rate and how they transmit to inflation.  

What data have we used?

The models in this Note are estimated from Q1 2004 to Q1 2024. The table below lists all the data series and their sources that are used to estimate the models.