The Function Bends: Inflation, Volatility, and Market Structure

The BIS evidence does not describe exchange-rate pass-through as a straight line. It finds that the estimated CPI response is modest in low-inflation environments, rises as inflation becomes higher, and follows a U-shaped relationship with exchange-rate volatility. This chapter explains how those two non-linear patterns can coexist, then connects them to economy size and the composition of imported goods. The goal is not to turn the observed thresholds into rules, but to understand why a linear average can conceal the state in which firms are deciding whether and how to change prices.

Inflation changes the pricing background

When inflation is low and stable, an exchange-rate movement enters a relatively quiet pricing environment. Firms may face a cost change without seeing a reason to revise all their prices immediately. They can wait for more information, preserve an existing customer price, or absorb a temporary movement in their margin. The BIS partial-effect estimates are consistent with this setting: pass-through is minimized when average inflation remains below roughly 5 percent.

Above that range, the fitted relationship rises. At an average inflation rate of 20 percent, the paper estimates a pass-through about twice as high as when inflation is near 2 percent. The important point is not that 5 percent is a universal boundary or that a country crosses it and automatically changes pricing behavior. The point is that the inflation environment helps determine how an exchange-rate movement is interpreted. When many prices are already being revised, a currency-related cost change may be incorporated more readily into the next price decision.

This relationship also changes the meaning of a stable exchange-rate estimate. Suppose two economies experience an exchange-rate movement of the same size. In the first, inflation has been low for a long period and firms expect the broader price environment to remain stable. In the second, inflation is already high and price changes are frequent. Even if the imported cost shock is identical, the second economy may show a larger CPI response because the movement is entering a different system of expectations and adjustment. The pass-through coefficient is responding to the surrounding inflation process as well as to the currency movement.

The BIS analysis reaches this conclusion through partial effects from a non-parametric model. It holds the other variables at their sample medians and traces how the fitted pass-through changes as average inflation varies. That is useful because a straight-line model would force the effect of moving from 2 percent to 10 percent inflation to look like a scaled version of the effect of moving from 10 percent to 20 percent. The random-forest result allows those regions to differ. It can therefore show a low-inflation floor and a later rise without imposing the shape in advance.

But a flexible curve does not identify the mechanism by itself.