Forget about hyperinflation, a falling dollar might not even cause moderate inflation in the U.S., at least according to Goldman Sachs’ Robin Brooks.
Historically, only a relatively small fraction of a Dollar fall is ‘passed through’ into consumer prices. For example, a paper by researchers at the Fed concludes based on data from 1981 to 2000 that a 10 per cent decline in the trade-weighted Dollar boosts inflation by only around 30 bps, a very small effect.
30 basis points of inflation, ie. 0.30%, is basically nothing relative to a 10% dollar decline, and we can thank foreign nations’ addiction to exports:
The small magnitude of this effect reflects a variety of factors, among which perhaps the most important is the desire of foreign exporters to preserve market share in the US, which means that they tend to react to Dollar falls by accepting smaller profit margins rather than hiking prices.
We update this analysis, by estimating a simple but popular Phillips curve specification that relates year-over-year core CPI inflation to the concurrent unemployment gap (measured by the distance of actual unemployment from the Congressional Budget Office’s estimate of the “natural” rate, currently at 5%), inflation expectations (measured by the 50th percentile of the Reuters/University of Michigan survey of longer term inflation), and the current and lagged year-over-year per cent changes in the GS broad Dollar trade-weighted index.
We estimate a similar magnitude for the pass-through as the Fed for data through 2000, but when we update the analysis for more recent data we find that the exchange rate pass-through into core CPI has fallen to essentially zero. This decline in pass-through is put down to the changing composition of imports in the academic literature, with the composition of imports changing over time towards goods with low pass-through.
The upshot is that inflation is far less of a threat than it seems, even with dollar-weakening policies from the U.S., while the flipside is that the U.S. could be emboldened to weaken the dollar much further because of this:
What all this points to is that – in line with the academic literature – the ‘pass-through’ from Dollar declines to US consumer price inflation is small. This in turn means that – if indeed the Fed sees the Dollar as one of its key policy levers for preventing inflation from staying below its mandate for a prolonged period – the Dollar needs to fall a lot further from here.
Ultimately, core CPI inflation remains hostage to the slowdown in rental (shelter) price and services (less shelter) price inflation – a point we have made repeatedly in our research and one of the main reasons why our bond forecasts have been below the forwards over the past 18-months. These components represent a significant component of the core inflation rate at approximately 31.9% and 28.3% respectively and are typically determined largely by domestic as opposed to external factors. And so as domestic conditions remain depressed, core inflation is likely to remain below levels the Fed would consider consistent with its mandate for some time.
(Via Goldman Sachs, Global Markets Daily, Robin Cook, 29 October 2010)