A Quarter Century of Inflation Targeting & Exchange Rate Pass-Through: Evidence from the First Three Movers

Abstract

This study has analysed the implications of Inflation Targeting for the Exchange Rate Pass-Through (ERPT) to inflation and trade balance. In this endeavour, we have focused on the first three movers i.e. New Zealand, UK and Canada. Drawing on the monthly data from October 1976 to September 2017, we employed a Time-Varying Structural Vector Auto-regressive framework in which the sources of time variation were both the coefficients and variance-covariance matrix of the innovations. Our key findings suggest that there is significant evidence of time-variation in the ERPT to inflation and trade balance in all three countries. In specific to inflation, the results showed that contrary to the notion that the ERPT to inflation has decreased in the Inflation Targeting economies, in fact, there is strong evidence that if there is anything, it is the other way around. The results using the ADF unit root test with a structural break (with innovation and additive outliers) suggested that the coefficients for inflation showed a decrease in oscillations which corresponded with the start of inflation targeting. However, this coincident cannot lead to infer that the ERPT has lost its significance. There is also a considerable amount of heterogeneity in the ERPT in the under-analysis countries. Specifically, in response to the positive Real Effective Exchange Rate (REER) shock, the inflation fell in the UK and New Zealand whereas, in Canada, it had the opposite effect. On the ERPT to the Trade Balance, the results on the UK showed a clear evidence of J-curve whereas in Canada, the impact was rather instantaneous and the trade balance quickly deteriorated. In New Zealand, the trade balance also showed deterioration in response to the REER shocks, although comparatively there was milder response than Canada and UK. Our findings have profound implications for monetary policy formulation under inflation targeting regimes and the influence of EPRT on price stability and external balance.

Keywords: Inflation Targeting, Exchange Rate Pass-through, Trade Balance, J-Curve, Monetary Policy, Zero Lower Bound

JEL Classification: E31, F31, F32