Getting low: the effects of a weaker Euro

“Insanity: doing the same thing over and over again and expecting different results.” Albert Einstein

Following last week’s European Central Bank (ECB) monetary policy meeting, Mario Draghi was very clear in stating that the Governing Council stood ready to embark on further monetary easing should the Eurozone growth and inflation outlook deteriorate further. More specifically, he said that the QE programme could be adjusted in size, composition and duration while deposit rates charged to banks be lowered into negative territory, if necessary. As he spoke, financial markets moved sharply. Euro-USD exchange rate fell sharply, from just above 1.135 to a low of 1.10. (For those who aren’t familiar with FX magnitudes, that’s a large move in a short space of time!). 

Draghi for the past two or three years has quite often made a point of ‘talking the Euro lower’, with phrases like ‘the Euro is increasingly relevant in our assessment of price stability’ and ‘a strong Euro is a cause for serious concern’, so this new signal of monetary easing could easily push the Euro lower still. The question then remains: what does a weaker Euro actually mean for growth and inflation? This post tries to address this question.

(OK - so I must confess, this topic is now significantly more relevant than when I first started thinking about this issue, but hey, I’ll take it!)

A good way to think about exchange rate effects on economic variables is by looking at exchange rate pass through (PT). Pass-through is normally associated with inflation, but choosing which inflation measure to look at is clearly paramount. In this case, the exchange rate should work primarily through the trade channel (affecting import and exports), and as such I define PT as the effect of a change in the exchange rate on import and export prices. To get a reasonable idea of the Euro area as a whole, I look at the four largest Euro economies - Germany, France, Italy and Spain - which account for 78% of Euro area GDP.

The theory

Basic economic theory suggests that for exchange rates to matter for the economy, there has to be large or 'full' PT. This is the idea that import prices move one-for-one with the exchange rate while export prices (denominated in the home currency) do not move at all. 

For example, if the EUR depreciates by 5%, full PT would require German import prices (in Euros) to rise by 5% and export prices to remain unchanged in Euros and hence fall by 5% in foreign currency terms. This rise by 5% in import prices would mean foreign goods are now more expensive, and domestic German goods relatively cheaper. Both foreign and German consumers then switch to buying German goods, leading to higher German growth. This, in economic parlance, is called the expenditure-switching effect.

In addition, those goods that were previously imported are now more expensive, so prices of goods in the ‘consumer basket’ are higher, pushing inflation higher. Note that this is based on the assumption that all exported goods are priced in the currency of the producer. But let us work with this simplifying assumption for now. 

What does the data say?

I collect and calculate monthly changes in import price (IPI) and export price (EPI) indices for each country (both in home currency and using country sources), Brent crude oil price (OIL) and the trade-weighted euro exchange rate (EUR). The data are monthly in frequency, beginning in January 1990 and are collected using Thomson Reuters Datastream. 

-------------------------------For the more technical reader--------------------------------

To analyse PT, I run two autoregressions, similar to those published in Gopinath & Burstein (2013) and Campa and Goldberg (2005). For imports, I regress import prices at time t on its own 6 lags, 6 lags of EUR and 6 lags of OIL. Similarly, for export prices, I regress export prices at time t on its own 6 lags, 6 lags of EUR and 6 lags of OIL. I then sum across the betas of 6 lagged EUR variables in both regressions (a common technique in PT empirical studies) to get sensitivities over a 6 months time frame.

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The charts above show the sensitivities (or ‘betas’) of the IPI and EPI in the 6 months following a change in the exchange rate. For illustrative purposes, France’s import price PT is -0.85, meaning that a 10% depreciation in the EUR would, on average, lead to a 8.5% rise in import prices over the next 6 months.

A few observations:

1) Export prices (in Euros) rise when the currency falls. This means that exporters raise the local currency price of their goods as the Euro depreciates. 

This is not what the theory says, and hence is a failing of the simple theory - export prices do to not show full PT. A simple example to drive this point home: Say Euros depreciated by 5%. Goods that would be normally 5% cheaper for foreign buyers are now only 1% or 2% cheaper because producers raise their price in Euros. This therefore means that import price PT is much higher than export price PT. 

2) The change in import prices is higher than export prices for each country. 

3) There are significant differences in the price sensitivities across the 4 countries.

Implications on the euro area:

Note that the ECB’s inflation mandate says that consumer price inflation (CPI) should be close to, but below 2% and that changes in the CPI can be broken down in domestic producer prices + import prices - export prices.

Assuming the change in exchange rate does not change domestic producer prices much, import prices will rise by more than export prices (observations 1 and 2) following a depreciation. This means that the change in import prices minus the change in export prices is positive, and so inflation rises. In other words: a euro depreciation should raise inflation across the Euro area.  

From observations 1 and 2, producers raise their export prices to offset the effective reduction in prices for foreign buyers arising from a currency depreciation. Consequently, demand will not increase as much as it would have done if they didn't raise the price (as the theory assumes). 

The end result?  The potential growth kicker from higher export volumes is dampened by firms’ pricing decisions. Moreover, even though import prices rise and hence domestic consumers buy more domestic goods, the boost to growth is likely to be lower than what people expect from a currency depreciation because of this dampened export PT.

Implications for country growth and inflation:

Now let’s combine this with observation 3. Import PT is the highest in Spain and France, while lowest in Germany and Italy. The mirror opposite applies to export PT. Let us take the two extremes, Germany and Spain, for illustration purposes.

On imports:

By only looking at PT rates, we can infer that a given depreciation in the Euro means higher growth in Spain than Germany - Spanish import are prices rise more than in Germany, so Spanish consumers switch to buying more domestic goods than German consumers, spurring growth.

Remember though, that Germany has the largest proportion of its trade with non-euro area members out of the big 4 countries. Interestingly, Germany seems well placed to take advantage of a depreciation from a trade perspective, but its poor import price PT means that it can’t. 

Conversely, Spain has the smallest proportion of its trade with non-euro area members, but has the largest PT. Though its import prices move a lot following a deprecation, it doesn’t actually matter for the economy because Spain predominantly trades with countries whose currency is also denominated in Euros.

On exports: 

Here, the story is the other way around. German firms’ decisions not to raise prices following a depreciation does mean cheaper goods for foreign buyers. Germany’s major trade links with non-euro area countries ends up being a major boon for its economy.

Spanish producers on the other hand choose to raise prices following a depreciation (more than Germany). In other words, the effective price of a good for a foreign consumer doesn’t change much even following a depreciation as Spanish producers raise its prices. Therefore, a depreciation doesn’t end up being a big deal for Spanish export growth.

The bottom line: 

There are two aspects that are required for a currency depreciation to have a meaningful effect. The first is a high pass through. The second is that the country must do a lot of trade with countries who have a different currency.

Draghi's message of a lower Euro has been a persistent narrative over the past few years and with more monetary easing on the horizon, a depreciating Euro is likely to continue for some time. When we take into account both trade links and the pass-through story, the analysis suggests a euro depreciation predominantly pushes German exports higher with little effect on much else. There are very little (first-round) effects on either the Spanish economy or German imports. It also follows that German growth is likely to be the major beneficiary of a euro depreciation, compared to Spain or France. 

In a world where euro-area growth has historically been very uneven as the Euro depreciates, this pass-through angle suggests that expecting anything different going forward would be nothing short of insane.