Exchange Rate Pass-Through to Inflation

If a country's currency falls 10% against the dollar, does the price of everything it imports simply rise 10% at the checkout counter? Rarely, and not right away. The fraction of an exchange-rate move that actually feeds through into domestic consumer prices is called exchange rate pass-through, and it is one of the most important — and most variable — numbers in a central bank's inflation forecast.

Why pass-through is incomplete and slow

Several frictions blunt the transmission from exchange rate to shelf price. Many exporters invoice in a stable currency like the dollar and simply eat some of the margin hit rather than repricing instantly, especially if they think the currency move might reverse. Retailers may have contracts fixing prices for months. Local production and services — a haircut, a restaurant meal — do not use imported inputs at all and barely move with the exchange rate regardless of how long you wait. And even the imported share of a consumer basket typically only adjusts with a lag of several quarters as old inventory sells through and new contracts are renegotiated.

The degree of pass-through varies systematically with an economy's structure: small open economies that import a large share of what they consume (many emerging markets) tend to see high, fast pass-through, sometimes above 50% within a year. Large economies like the US, where imports are a smaller share of the consumption basket and much trade is invoiced in the country's own currency, typically see pass-through well under 20%.

Worked example

Suppose a small open economy's currency depreciates 20% against the dollar over a year, and estimated pass-through to consumer prices is 40% over that horizon. The exchange-rate move alone would then be expected to add roughly 20% x 0.40 = 8 percentage points to headline inflation over the year, layered on top of whatever domestic inflation pressures already existed. If the central bank's other inflation drivers were already running at 3%, total inflation might land near 11%, and — crucially — most of that 8-point contribution arrives with a lag, so the worst of the inflation print may not show up until two or three quarters after the currency move itself.

What this means in practice

Central banks use pass-through estimates to decide how much of a currency-driven inflation spike to "look through" as temporary versus respond to with rate hikes. A central bank with low estimated pass-through can afford to be more patient about a currency depreciation; one in a high-pass-through economy often has to react faster and harder, because the same currency move will hit consumer prices — and inflation expectations — much sooner and more fully.