International trade ; Dollar, American ; Balance of payments ; Prices

Ramon Moreno

Reuven Glick

English

Research Papers in Economics

FABSF WEEKLY LETTER
December 12, 1986
The Pass-ThroughEffecton U.S. Imports
Despite the 35 percent depreciation ofthe dollar
since its peakinEebruaryJ985, the volumeof
United States imports has remained high. In fact,
net exports of goods and services - total
exports minus total imports - worsened in the
second quarter of 1986 to a deficit level of
around $150 billion in 1982 dollars.
A previous Letter (September 26, 1986) dis-
cussed how much of an improvement in the
trade balance could have been expected by now
on the basis ofthe historical relationship
between the trade balance and its traditional
determinants - the exchange rate and u.s. and
world GNP. It concluded that predictions based
on historical relationships, which fit recent expe-
rience reasonably well through the first quarter
of 1986, increasingly overstated the improve-
ment in the trade deficit in the last few quarters.
Much of this prediction error was due to under-
estimates of the level of imports.
A number of reasons have been proposed for the
apparent delay in the anticipated decline in U.s.
imports and turnaround in the current u.s. trade
picture. Among them is the possibility that for-
eign exporters, having benefitted from high
profits when the dollar was strong, are now
choosing to limit price increases and to sacrifice
profit margins on exports to the u.s. to preserve
their share ofthe huge u.s. market.
This Letter explores the extent to which the rela-
tionship between changes in the exchange rate
and changes in import prices, known asthe
pass-through relationship, may have changed
significantly in recent years. Ifforeign exporters
of products into the United States are indeed
passing changes in the value of the dollar
through to U.S. import prices more slowly than
in the past, then the anticipated turnaround in
the u.s. trade balance may take longer than his-
tory would suggest.
The pass-through effect
U.S. import prices reflect the costs in dollars of
purchasing goods produced abroad. These costs,
in turn, depend on the costs of foreign pro-
ducers, the exchange rate, and on the profit mar-
gins desiredbyforeign exporters. For example,
one would expect import prices to rise ifcosts in
Japan increase. Similarly, one would expect
higher import prices if the dollar depreciates
against the yen (making the yen more expen-
sive), or if foreign exporters increase their profit
margins.
The extent to which import prices adjust to
reflect changes in the cost offoreign goods
resulting from a dollar depreciation or apprecia-
tion is known as the "pass-through". In very
competitive markets, foreign exporters have
small profit margins and are forced to pass
through changes in the value of the dollar to
u.s. import prices very quickly. However, in
markets that are not very competitive, profit
margins are large and foreign exporters may pre-
fer to absorb changes in the value of the dollar
by altering their profit margins. The pass-through
to import prices is then quite small. A small
pass-through would therefore tend to reduce the
effect of exchange rate changes on U.S. con-
sumers' demand for foreign goods.
A popular current explanation for the seemingly
slow turnaround in the U.S. trade balance is that
foreign exporters were able to increase profit
margins substantially during the period (up to
1985) in which the dollar was sharply appreciat-
ing, and that they cushioned the impact of the
subsequent dollar depreciation by reducing their
profit margins rather than by raising their export
prices proportionately. They preferred to reduce
their profit margins presumably to protect their
market shares. Although changing profit margins
have in the past caused delays in the pass-
through, the unusually sharp rise in the dollar's
value in the 1980s may have resulted in a
slower pass-through in recent quarters than
would be suggested by historical experience.
The data appear to confirm this hypothesis. In
the 18 months up to August 1986, the dollar
depreciated 41 percent against the yen, 38 per-
cent against the German mark, and 26 percent
against the British pound. (At the same time,FRBSF
inflation in these countries was comparable to
that in the United States.) But the (unit value)
prices of non-oil imports increased only 4 per-
cent overthis period - a much smaller percent-
age change than the dollar depreciation.
A better picture of the pass-through and implica-
tions forthe competitiveness of US. goods
comes from comparing changes in the real
trade-weighted value of the dollar to a measure
ofthe relative import price. A strong pass-
through effect would imply that increases
(decreases) in the real value of the dollar should
show up closely in decreases (increases) in rela-
tive import prices.
The real value ofthe dollar is the nominal value of
the dollar adjusted for inflation in the U.s. and
abroad. It can be interpreted as a measure ofthe
relative cost offoreign and u.s. goods. The lower
the real value of the dollar, the more costly are
foreign goods compared to U.s. goods. The rela-
tive import price isthe ratio of u.s. non-oil import
prices tothe U.s. price level. It reflects the actual
pricecharged for imported goods in the u.s. mar-
ket in comparison to domestic prices. The higher
the relative import price, the less competitive are
foreign imports.
Up to 1983, as shown in Chart 1, there was a
strong tendency for relative import prices to fall
when the dollar appreciated. (It is also worth
noting that between 1980 and 1983, nominal
import prices were essentially flat, while relative
import prices fell. u.s. inflation was high
enough for foreign suppliers tomakecompeti-
tive gains without havingto reduce their prices
in response to the dollar appreciation.)
Chart 1 also suggests that the pass-through of
real exchange rate changes to relative import
prices has slowed since 1983. From the third
quarter of 1983 to the end of 1984, relative
import prices declined 1/8 of one percentfor
every percent appreciation in the real value of
the dollar-down from a 1/2 percent decline
fOr the same appreciation from·1980to the sec-
ond quarter of 1983 (marked with a vertical line
in Chart 1).
Foreign suppliers apparently did not think it
necessary to exploit the improvement in their
price competitiveness, afforded by the dollar
appreciation, by lowering U.s. import prices
more sharply. This supports the view that they
were able to increase their profit margins sub-
stantially during this period.
The sharp dollar depreciation after the first quar-
ter of 1985 was similarly associated with a com-
parativelysluggish response in import prices:
relative import prices did not increase until the
second quarter of 1986. U.S. imports may have
remained high partly because this improvement
in U.S. competitiveness took so long to appear.
A change in the relationship between the
exchange rate and import prices is also indi-
cated by the relationship between the behavior
of import prices and the nominal exchange rate
and foreign prices, over two periods - from the
fourth quarter of 1972 to the second quarter of
1983, and from the fourth quarter of 1972 to the
second quarter of 1986. These two periods were
chosen because the sharp deterioration in the
u.s. trade position began after the second quar-
ter of 1983 and there were no signs of changes
in pass-through before then.
For both periods, about 80 percent of the effect
of exchange rate changes was passed through
after eight quarters. However, the pass-through
of exchange rate changes to import prices after
four quarters was much less over the longer
period when only 40 percent of the exchange
rate change took place as compared to 60 per-
cent for the shorter period.
As a result, our predictions of the import price
since the second quarter of 1983 (and through
the second quarter of 1986), based on the histor-
ical relationship between the exchange rate and
import prices before then, underestimated the
effect ofthe rising dollar on the actual fall in
import prices when the dollar was appreciating,
and overpredicted the effect of the depreciating
dollar on the actual rise in import prices in the
last three quarters. The cumulative pass-through
after eight quarters, however, was much closer
for the two periods, suggesting that, although the
speed of the pass-through has slowed, its total
long-run magnitude may not have changed very
much.
Implications for u.s. imports
The preceding discussion implies that, in recentIndex
1980 = 100
Chart 1
The Pass-Through Effect has Slowed
in Recent Years
Chart 2
Import Prices Predict Import Volume Better
Billions
1982 $
180 475
1983Q2
1972 1974 1976 1978 1980 1982 1984 1986 1986 1985
Actual Import Volume
1984 1983
425
400
450
325
375
350
300 L- -'- L- -'- ---'
\
\
\~,
'....----,
'--'
,--, ' .........1 " " ....--,-,' -' ,-' Relative Import Prices
~, 80
160
120
100
140
quarters, the import price should be a better pre-
dictor of developments in the u.s. trade balance
than the real exchange rate because of changes
in the pass-through relationship. To confirm this
view, we studied two historical relationships
through the second quarter of 1983: the first
involved real exchange rates, and the second,
import prices, to explain the volume of real
imports. We then used the two relationships to
predict import volume from the third quarter of
1983 to the second quarter of 1986 and com-
pared those predictions to the actual volume of
imports.
The results, illustrated in Chart 2, indicate that
predictions based on import prices in recent
quarters tracked actual import levels more
closely than those based on the real exchange
rate. The improvement in forecasts of imports
using import prices is particularly apparent from
early 1985 on.
Conclusions
Our results indicate that the pass-through of
exchange rates to import prices over the first
four quarters after a change in the exchangerate
has become significantly smaller in the last three
years than before. Our findings also indicate that
the current response of import prices, over the
first eight quarters following a change in the dol-
lar, appears to be almostas large as it has been
in the past. Although the pass-through may have
slowed,the total long-run pass-through is about
the same.
This suggests that while a reduction in imports in
response to the dollar depreciation may be
delayed, a significant improvement can be
expected incoming quarters. The reported
reduction in the trade deficit in the third quarter
of1986 is consistent withthis view.
These conclusions must be tempered by the per-
formance of import pricesin predicting import
volume. Although import prices have been bet-
ter predictors than real exchange rates in recent
quarters, both have tended to underpredict
imports by increasing amounts. Ifthese errors
persist, other explanations must be found for the
continuedgrowth in U.S. imports.
Reuven Glick and Ramon Moreno
Opinionsexpressed in this newsletterdo not necessarily reflect theviews of themanagementofthe Federal Reserve 8ankofSan
Francisco, orofthe 80ardofGovernorsofthe Federal Reserve System.
Editorialcommentsmaybe addressedtotheeditor(GregoryTong) ortothe<luthor.... Fr~copiesofFederal Reservepublications
can be obtainedfrom the Public Information Department, Federal Reserve BankofSan Francisco, P.O. Box 7702,San Francisco
94120. Phone (415) 974-2246.uo~6U!4S0m 4o~n uo61:lJO 0POM~U
040PI !!omOH O!UJOj!l0) ouoz!J~ o~sol~
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollaramounts in millions)
SelectedAssets and Liabilities
Large Commercial Banks
Amount
Outstanding
11/19/86
Change
from
11/12/86
Change from 11/20/85
Dollar Percent?
Loans, Leases and Investments] 2 204,717 1,359 6,803 3.4
Loans and Leases1 6 184,337 1,649 4,879 2.7
Commercial and Industrial 50,749 673 - 725 - 1.4
Real esJate 67,188 127 1,411 2.1
Loans to Individuals 39,581 105 1,753 4.6
Leases 5,575 - 15 161 2.9
U. S. Treasury and Agency Securities2 12,513 - 266 1,343 12.0
OtherSecurities2 7,868 - 23 580 7.9
Total Deposits 206,131 -4,193 5,076 2.5
Demand Deposits 53,326 -4,272 4,517 9.2
Demand Deposits Adjusted3 36,065 -1,950 - 8,341 -18.7
OtherTransaction Balances4 18,203 - 155 3,836 26.7
Total Non-Transaction Balances6 134,601 233 - 3,277 - 2.3
MoneyMarketDeposit
Accounts-Total 46,903 575 1,196 2.6
Time Deposits in Amounts of
$100,000 or more 32,663 - 261 - 5,713 -14.8
Other Liabilities for Borrowed MoneyS 27,715 2,211 3,134 12.7
Two WeekAverages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+l/Deficiency(-)
Borrowings
Netfree reserves (+l/Netborrowed(- l
Penod ended
11/17/86
66
63
3
Penod ended
11/3/86
21
64
42
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading accountsecurities
3 Excludes U.S. governmentand depository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephone transfers
S Includes borrowingvia FRB, IT&L notes, Fed Funds, RPs and other sources
6 Includes items notshown separately
7 Annualized percentchange

The pass-through effect on U.S. imports

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The pass-through effect on U.S. imports

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