Banco de España: Recent movements in the euro exchange rate and the impact on inflation in the Spanish economy

Banco de España has just published the article “Recent movements in the euro exchange rate and the impact on inflation in the Spanish economy”. The effect of the euro exchange rate on inflation has taken on significant importance recently, with the application of the ECB’s expansionary monetary policy measures having coincided with episodes of euro appreciation, such as that observed between the second half of 2017 and early 2018, which tend to exert downward pressure on imported prices.

This article analyses the factors behind the fluctuations in the euro exchange rate against the dollar during the recent period, and finds that this appreciation may have largely been due to the higher relative growth of the euro area, compatible with a pick-up in expected euro area inflation. However, the subsequent depreciation, since February 2018, might reflect factors related to changes in the relative confidence of financial markets to the detriment of the euro, and to the lower relative growth of the euro area compared with the United States.

Further, it is documented how the pass-through of exchange rate movements to overall consumer-price inflation in the Spanish economy has increased slightly in recent years, owing mainly to the energy component, while core inflation remains much less sensitive to exchange rate changes.

Key factors

In the context of flexible foreign exchange markets, such as those for the euro and the dollar, the exchange rate is a relative price that reacts to any news or information that changes perceptions of the value of the real and financial assets of the economies whose currenciesit links.

The euro area economies, Spain among them, are highly integrated into the global economy at the productive, trade and financial levels. Consequently, the exchange rate is a key component in determining their prices. Changes in the euro rate feed through to import prices and from there to the entire price chain and, ultimately, to the overall level of consumer prices.

Hence, appreciations of the euro on the scale observed to February this year normally entail lower import prices and, therefore, downward pressure on producer and consumer prices. Moreover, against a background of continuing low inflation such as that marking the euro area in recent years, the appreciation of the euro may have a contractionary effect on the economy’s financial conditions and ease the intensity of the transmission of the recent monetary policy expansionary measures aimed at moving inflation in a sustained manner up towards the ECB’s objective, with medium-term inflation rates lower than but close to 2%.

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