Morning Brief – Pass Through

Charles Porter
Tue 14 Feb 2023

Pass Through

The so-called pass through rate measures the sensitivity of a country’s inflation dynamics to changes in the value of its local currency. In truth, although the term is used to describe causality between currencies and the price level, the effect does run both ways with inflation impacting the exchange rate at the same time as currency values affect the rate of change in domestic price levels. For the purposes of economics, the term is almost exclusively used to determine how a change in the value of a local currency will impact the domestic rate of inflation. For the past decade, it has been noted that the pass through effect has been very weak. When currencies have been on the move lower, the rising cost of overseas products using domestic capital has typically not fed through to headline inflation as it might usually be expected to. This has been because we have been living in a globally low inflation environment where compensating factors or policy have been able to block the feedback between currency value and the price level.

You will agree with me I’m sure that we are no longer in such a globally low inflation environment, far from it. There is the significant risk therefore that instability in exchange rates could have an out-sized impact upon domestic inflation. Because we do not live in the bubble of this economic theory we also know that this changing price level would in turn make exchange rate deterioration more severe. This has the potential to create pockets of risk where vicious cycles can manifest to force sudden changes in the FX market. Those currencies most vulnerable are those of emerging markets but also currencies where foreign direct investment has, or could easily, become limited.

One of the main pressure points for such emerging market currencies is the presence of a strong US Dollar. With a stronger Dollar, the risk of currency volatility within emerging markets is elevated making an understanding of the pass through rate even more critical to currency analysis. Whilst the Dollar had been weakening significantly with many analysts pointing to the peak of the USD cycle, it has begun to strengthen once again. By deteriorating the fiscal stability of emerging markets forced to issue debt in hard currency and generally applying a dampening force to global economic activity, USD strength has a meaningful and detrimental impact upon emerging market FX. This is therefore a sector of the currency market that could, and arguably should, see higher levels of implied and realised volatility over the next few quarters. When it does, focus will be in the pass through rate to see how deep the localised falls in many emerging market currencies will be.

Discussion and Analysis by Charles Porter

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