THE FEDERAL RESERVE’S DOLLAR DISTRACTION

In its September policy statement, the US Federal Reserve took into consideration — in a major way — the impact of global economic developments on the US, and thus on US monetary policy. Indeed, the Fed decided to delay raising interest rates partly because US policymakers expect dollar appreciation, by lowering import prices, to undermine their ability to meet their 2% inflation target.

In reality, while currency movements can have a significant impact on inflation in other countries, dollar movements have rarely had a meaningful or durable impact on prices in the US. The difference, of course, lies in the US dollar’s dominant role in the invoicing of international trade: prices are set in dollars.

Just as the dollar is often the unit of account in debt contracts, even when neither the borrower nor the lender is a US entity, the dollar’s share in invoicing for international trade is around 4.5 times America’s share of world imports, and three times its share of world exports. The prices of some 93% of US imports are set in dollars.

In this environment, the pass-through effect of dollar movements into non-fuel US import prices is one of the lowest in the world, in both the short term (three months out) and the longer term (two years out), for three key reasons. First, international trade contracts are renegotiated infrequently, which means that dollar prices are “sticky” for an extended period — around 10 months — despite fluctuations in the exchange rate.

Second, because most exporters also import intermediate inputs that are priced in dollars, exchange-rate fluctuations have a limited impact on their costs and thus on their incentive to change dollar prices. And, third, exporters who wish to preserve their share in world markets — where prices are largely denominated in dollars — choose to keep their dollar prices stable, to avoid falling victim to idiosyncratic exchangerate movements.

What little impact import price shocks have on US inflation is highly transitory, with most of the effect tapering off after just two quarters. A sharp 10% appreciation of the US dollar, for example, would reduce inflation for non-fuel imports by 4.4% cumulatively over the next two to three quarters, but would have only a negligible impact on inflation after that point.

If one accounts for consumer goods expenditure on imports, that 10% appreciation would lower inflation, as measured by the consumer price index (CPI), by just 0.5 percentage points in the first two quarters. And that is likely to be an upper bound, because it assumes that US retailers will pass through to consumers the full amount of any increase in import prices.

In practice, they are more likely to increase retail markups and lower cost pass-through. The estimated price passthrough for imported manufactured goods, which would better represent what enters the consumption bundle, is even lower than that for all nonfuel imports.

Although these factors insulate the US from the inflationary pressures stemming from exchange-rate fluctuations, they increase the vulnerability of other countries, especially emerging economies. Because the dollar prices of most of these countries’ imports are not very responsive to exchange-rate movements, the pass-through effect of those movements into import prices denominated in their home currencies is close to 100%.

The impact of exchange-rate movements on inflation in most countries is thus 3-4 times larger than in the United States. A 10% depreciation of the Turkish lira, for example, would raise cumulative CPI inflation in Turkey by anywhere from 1.65 to 2.03 percentage points, over two years, all else being equal.

Despite this imbalance, the dollar’s dominance as an invoicing currency is unlikely to change anytime soon — not least because bringing about a shift would require coordination among a huge number of exporters and importers. The euro might seem like a strong contender, given the volume of trade among euro zone countries, but outside Europe, the currency is not used nearly as widely as the dollar.

In deciding when to normalise interest rates, the Fed has placed considerable weight on the weakness of inflation, and its global underpinnings. But while it is true that some global developments — especially falling commodity prices, and perhaps also slowing emerging-economy growth and rising financial volatility — may push down inflation, dollar appreciation will not, at least not in any meaningful way. A stronger dollar thus is not a legitimate reason to delay the normalisation of US interest rates.