With the dollar depreciating, can inflation be far behind?

09.29.09

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Many people believe that a falling dollar in the foreign-exchange market portends future inflation, and they do so for a very good reason: a monetary impulse is very likely to cause the dollar to fly south well before consumer prices take off. Unfortunately for forecasting buffs, other factors besides monetary spurts affect dollar exchange rates, and these things muddy the ability of exchange-rate changes to forecast future inflation patterns. All and all, exchange rates do contain useful information for predicting inflation, but forecasting inflation simply with an exchange rate is a little like eating dinner with only a knife.

The dollar has lost a lot of ground in the past few years, heightening concerns among some people about future inflation. Relative to the currencies of the other major developed countries, the dollar has depreciated 40 percent since its peak in February 2002. If we toss the currencies of the key developing countries into the mix, the pattern in only slightly better. The dollar has depreciated 23 percent since early 2002 by this broader measure. Although the dollar reversed course through much of last year, it once again seems to be on a downward trajectory.

The connection between an exchange rate and inflation is neither simple nor straightforward, because the relationship depends on how each respond to money impulses. Inflation, after all, is a drop in the purchasing power of money that results when a central bank creates more money than the public wants to hold. As the public subsequently unloads the unwanted money for goods and services, all prices, including wages, eventually rise. If the public also exchanges the unwanted money for foreign goods and services, the dollar will depreciate in the foreign-exchange market. While inflation eventually leads to a rise in all prices, it does not do so evenly. Some prices respond to monetary impulses faster than others. Many prices are set under contracts or by custom and adjust only at discrete intervals. Exchange rates, however, adjust continuously. Moreover, foreign-exchange traders are highly efficient processors of information. If they believe that monetary policy will produce inflation down the road, they are very likely to build that expectation into their exchange-rate quotes today. For these reasons, if the Federal Reserve creates too much money, the dollar is very likely to depreciate well in advance of any rise in the consumer price index or any other price measure.

Unfortunately, exchange rates also respond to other things besides domestic monetary impulses. Foreign inflation rates are just such a factor. Strictly speaking, exchange-rate changes reflect international inflation differentials, not the absolute level of inflation in a specific country. If the United States maintains a 3 percent inflation rate year in and year out but the rest of the world consistently maintains 1 percent inflation rate, the dollar will tend to depreciate by 2 percent per year. If then both the U.S. and world inflation rates rise by 1 percentage point, the dollar will continue to depreciate by 2 percent per year, and this depreciation does not forecast a change in the U.S. inflation rate. Exchange rates can also change for reasons that don't have anything to do with inflation. If China, Brazil, of Europe look like better investment sites than the United State, funds will flow away from the United States and to these places, and the dollar will depreciate against their currencies.

When push comes to shove, this is an empirical issue, so we investigated whether percentage changes in the Board of Governors' Broad and Major currency indexes contain useful information for predicting changes in future inflation rates. The results were mixed. We did find pretty clear evidence that changes in these exchange-rate indexes are useful for predicting changes in inflation as measured by the Federal Reserve Bank of Cleveland's median CPI. We also found that the signal was not confused because the effect also tan in the opposite direction: inflation changes induced movements in the exchange rates. The median CPI attempts to offer a cleaner measure inflation trends than other price indexes by abstracting as much as possible from the influence of individual price changes, such as jumps in petroleum prices.

We also found evidence that movements in these exchange-rate indexes predicted changes in inflation as measured by the headline CPI, but you need 12-months' worth of data before you get any information. These same exchange-rate movements, however, ate not useful for predicting changes in inflation after you strip out food and energy prices to get the core CPI. In addition, the results show that changes in the inflation rate, as measured by either the headline CH or the core CPI, help predict changes in our two exchange-rate indexes over short intervals.

In an empirical sense then, exchange-rate changes do contain some information about future changes in inflation rates, but the results ate not robust across alternative measures of inflation. Because of this lack of robustness and for the reasons outlined above, no one should "bet the ranch" on exchange-rate-based prediction of inflation. Most economists look at a whole slew of data--from GDP gaps to commodity price trends--before forming opinions about inflation trends. Exchange rates should be in the mix and used with caution.

Do Exchange-Rate Movements Predict
Changes in the Inflation Rate?

                       Inflation measure

Exchange rate         CPI   Core   Median

Broad
  lags include    4   No     No       No
                  8   No     No      Yes
                 12   Yes   Yes       No
                 18   No     No       No
Major
  lags include    4   No     No      Yes
                  8   No     No      Yes
                 12   Yes    No       No
                 18   No     No       No

Sources: Haver Analytics, Board of Governors of the Federal
Reserve System, U.S. Department of Commerce, Federal Reserve
Bank of Cleveland.

Do Changes in the Inflation Rate Predict
Exchange-Rate Movements?

                       Inflation measure

Exchange rate         CPI   Core   Median

Broad
  lags include    4   Yes    No       No
                  8   Yes    No       No
                 12   No     No       No
                 18   No     No       No
Major
  lags include    4   Yes    No       No
                  8   Yes    No       No
                 12   No     No       No
                 18   No     No       No

Sources: Haver Analytics, Board of Governors of the Federal Reserve
System, U.S. Department of Commerce, Federal Reserve Bank of Cleveland.