The Exchange Rate and Import Prices

Speaking of the J-curve… the BLS released data this morning on the price of imports into the US. Import prices rose by nearly 7% during 2004, which is a considerably faster rate of growth than the 2.4% rise during 2003. This was due to two things: the rise in oil prices (which comprises a large portion of US imports, of course), and the fall in the value of the dollar.

We can focus on the second effect by looking at the price of non-oil imports, which rose by 3.8% in 2004. This compares to an increase in non-oil import prices of just 1.2% in 2003, and an overall inflation rate in the US of about 2.3% for all non-oil consumer goods (both imported and domestically produced) in 2004 (Nov. to Nov.).

These import inflation numbers may strike you as surprisingly low. After all, the dollar has lost over 15% of its value (in real effective terms) over the past two years, yet import prices have risen by just a percent or two more than overall prices in the US. In fact, the chart below illustrates that the connection between the exchange rate and import prices is surprisingly weak.

A strong dollar should make imports cheap, and a weak dollar should make imports expensive. Yet import prices have changed very little in recent years despite substantial swings in the value of the dollar.

Why? It’s an old story called exchange rate pass-through. Firms that sell imports in the US seem to prefer to earn higher margins when the dollar is strong, and accept lower margins when the dollar is weak, rather than muck about with dramatic price changes. Which suggests, of course, that hoping that a weak dollar will fix the US’s trade deficit may be wishful thinking…