Exchange Rate Shocks and Inflation Comovement in the Euro Area

Abstract

This paper decomposes the time-varying effect of exogenous exchange rate shocks on euro area countries inflation into country-specific (idiosyncratic) and region-wide (common) components. To do so, we propose a flexible empirical framework that is based on dynamic factor models subject to drifting parameters and exogenous information. We show that exogenous shocks to the euro/USD account for over 50% of the nominal euro/USD exchange rate fluctuations in more than 1/3 of the quarters over the past six years – especially in turning points periods. Our main results indicate that headline inflation in euro area countries, and in particular its energy-related component, has significantly become more affected by these exogenous exchange rate shocks since the early 2010s, in particular, for the largest economies of the region. While such increasing sensitivity relies solely on a sustained surge in the degree of comovement for headline inflation, it is also based on a higher region-wide effect of the shocks for the case of energy inflation. Instead, purely exogenous exchange rate shocks do not seem to have a significant effect on the core component of headline inflation, which also displays a lower degree of comovement across euro area countries.

Keywords: exchange rate, inflation, factor model, structural VAR model

JEL Classification: E31, F3, F41