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Exchange rate pass-through and inflation targeting in Peru

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Abstract

It has been widely documented that the exchange rate pass-through to domestic inflation has decreased significantly in most of the industrialized world. As microeconomic factors cannot completely explain such a widespread phenomenon, a macroeconomic explanation linked to the inflationary environment—that a low and more stable inflation rate leads to a decrease in the pass-through—has gained popularity. Using a structural VAR framework, this paper presents evidence of a similar decline in the pass-through in Peru, a small open economy that gradually reduced inflation to international levels in order to adopt a fully fledged inflation targeting scheme in 2002. It is argued that the establishment of a credible regime of low inflation has been instrumental in driving the exchange rate pass-through down.

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Notes

  1. This channel is stronger if prices of some non-tradable goods or services, for instance rent, are set in dollars. In the Peruvian case, about 20 % of items in Lima CPI (the inflation indicator the central bank targets) are either imported or priced in dollars.

  2. For previous studies on the exchange rate pass-through in Peru, see Winkelried (2003) and the references therein.

  3. It is worth mentioning that a rather popular tool to analyze pass-through effects is the error correction model (ECM), which is just a VAR model in differences (e.g., inflation rates) augmented by a term to preserve cointegration among the levels (e.g., price indices). However, as stressed by Hendry (2006), inferences based on the ECM’s forecast function (tightly related to the IRF) can be seriously distorted due to deterministic breaks in the underlying cointegrating relationships. In view of this, we follow Hendry’s recommendation of ignoring the error-correcting terms and work with a VAR in differences. This approach should render more robust inferences when the data is suspected to be subject to deterministic breaks (either temporary or permanent).

  4. In fact, the less striking differences in the pass-through on impact \((h=0)\) with respect to its long-run counterpart \((h \rightarrow \infty )\) reported in Fig. 2, suggest that it is the inherent dynamics of the VAR model what is important for the long-run results, rather than the size of the initial shock.

  5. It is worth mentioning that a full set of estimations which use growth rates instead of cycle are considered in the working paper version of this article (Winkelried 2011).

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Acknowledgments

I would like to thank Adrián Armas and seminar participants at the Central Reserve Bank of Peru for helpful comments. I am also grateful to an anonymous referee for very useful suggestions. The usual disclaimer applies.

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Authors and Affiliations

  1. Central Reserve Bank of Peru, Jr. Miró Quesada 441, Lima 1, Peru

    Diego Winkelried

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  1. Diego Winkelried
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Correspondence to Diego Winkelried.

Data appendix

Data appendix

Table 1 describes the data. For each variable in the VAR the first definition is used in the base model of Sect. 3.2, whereas the others feature the robustness checks of Sect. 3.3. Most of the series are available online at the BCRP’s website (http://www.bcrp.gob.pe/statistics.html) and are regularly published in its Weekly Report (Nota Semanal). When applicable, the column “Source” in Table 1 shows the page number of the Weekly Report where each series can be found. The data on wholesale price indices used to measure importer and producer prices come from the National Statistical Office (INEI) and are also available online (http://iinei.inei.gob.pe/iinei/siemweb/publico).

Table 1 Data description
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Winkelried, D. Exchange rate pass-through and inflation targeting in Peru. Empir Econ 46, 1181–1196 (2014). https://doi.org/10.1007/s00181-013-0715-4

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