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How Exchange Rates, Commodity Prices and Uncertainty Create an "Inflation Puzzle"

By Frances Coppola

International businesses trying to understand the future direction of currency exchange rates have a right to feel quite perplexed by the current, almost daily flow of headlines regarding the "inflation puzzle" being wrestled with by many of the world's central banks. After all, there is an established relationship between inflation and exchange rate movements. This article offers a quick overview of the relevant monetary policy history leading up to today's inflation puzzle, and explores the challenges that puzzle presents.

Targeting Inflation Rather than Exchange Rates Helped Create the "Great Moderation"


The collapse of the Bretton Woods gold-backed financial system in the early 1970s heralded a period of high inflation in most Western countries. Central banks eventually brought this under control by means of very high interest rates. In 1981, the effective U.S. Federal Funds Rate reached the historically unprecedented1 level of nearly 19 percent.2 From this time on, controlling inflation gradually replaced managing exchange rates as the primary task of central banks. By the mid-1990s, all major central banks except the People's Bank of China had abandoned explicit exchange rate management in favor of maintaining price stability, and the gold standard had become a memory. Now, the world's financial system consists entirely of fiat currencies, many of them floating freely against each other.


The period between the mid-1980s and the 2007-8 financial crisis is often known as the "Great Moderation." because during that period inflation remained low and stable. Economists think that this was due to central banks actively targeting inflation rather than exchange rates.3 During this time, interest rates gradually fell, largely due to the decline in inflation.4 Allowing exchange rates to float did not cause high volatility: the U.S.'s trade weighted exchange rate rose until about 2000, then fell again after the dot com crash and the 9/11 terrorist attack,5 while sterling's trade weighted exchange rate stabilized after the U.K.'s exit from the European Exchange Rate mechanism in 1992.6


For businesses, this period of calm created a degree of certainty regarding price levels, both within their own countries and internationally, which encouraged them to develop new import-export businesses. The opening up of developing countries, particularly after China's accession to the World Trade Organization in 2001,7 enabled international businesses to expand into new countries. During the Great Moderation, international trade expanded considerably, helped by low inflation and interest rates and the development of new FX hedging products to help businesses manage exchange rate risk.8


The End of the Great Moderation, and the Start of the Inflation Puzzle


The Great Moderation ended abruptly with the fall of Lehman Brothers in 2008, which caused a deep recession in Western economies and a "sudden stop" in many developing countries.9 Central banks cooperated to support the international financial system, while governments embarked on a coordinated program of fiscal stimulus to ward off a 1930s-style depression. By 2010, the worst appeared to be over: economic growth was returning, and banks were beginning to repair themselves. Massive monetary and fiscal stimulus had successfully prevented a damaging deflationary spiral like that in the 1930s. But the inflation puzzle was only just beginning.


In the latest Geneva Report on the World Economy, four economists show that after the 2008 financial crisis, central banks believed that the combination of a very deep recession with very large rises in commodity prices would cause sharp swings in inflation. "Around 2010, pretty much all standard theories seemed to point towards volatile and potentially unanchored inflation." they say.10 But the expected volatility never materialized. Exchange rates and commodity prices varied wildly, but core inflation in developed countries remained low and stable. Why was this? Will it remain the case?


The Unexpected Stability of "Core" Inflation


Although central banks' inflation target is usually set as the rate of growth of consumer prices, they often prefer to measure "core" inflation, which strips out volatile items such as oil prices. This enables them to see through short-term changes in volatile items to the underlying upwards or downward trend in the general price level.11


Core inflation in most Western countries has indeed remained low and stable since the Great Recession. In the U.S., for example, it has hovered between 1 and 2 percent since October 2008.12 This is the "inflation puzzle." Some economists think that the reason why core inflation has remained low is the fact that wage growth and productivity are both lower than before the Great Recession.13 Others suggest that the impact of globalization means that the level of unemployment at which inflation starts to rise is lower than previously thought.14


How Exchange Rate and Commodity Price Volatility Have Affected Consumer Price Inflation


But consumer price inflation including the volatile items has not stayed low and stable. Since the fall of Lehman Brothers, it has been significantly more volatile. In the U.K., inflation rose from 2010 onwards, peaking at over 5 percent in September 2011.15 In the Eurozone, consumer price inflation rose sufficiently in 2010-11 for the ECB to raise interest rates twice:16 this decision is credited by some economists as triggering the Eurozone crisis.17 And in the U.S., consumer price inflation since the fall of Lehman shows large swings, from minus 2 percent (deflation) in June 2009 to nearly 4 percent in September 2011.18


The Geneva researchers say that much of the U.K.'s high post-crisis inflation was due to an overall 25 percent depreciation of sterling's exchange rate.19 For an import-dependent economy like the U.K., a double-digit exchange rate depreciation can cause consumer price inflation to rise, as the sterling prices of essential imports (notably oil and foodstuff) increase. Sterling has depreciated by over 10 percent twice since the crisis, in 2008-9 and again in 2016, and on each occasion the result has been higher inflation.


Exchange rate depreciation is a short-run effect: the effects take a year or two to feed through to inflation, but then disappear again within another year or two unless there are further falls. After the exchange rate depreciation of 2008-9, the Bank of England's (BoE's) policymakers decided not to raise interest rates in response to higher inflation. They even re-started QE in 2012 when inflation was well above target. The researchers show that the BoE's willingness to allow inflation to rise above target temporarily helped to anchor inflation expectations, since it showed that policymakers treated the 2 percent target as a medium-term average rather than a ceiling.20


Conversely, recent below-target inflation in the U.S. is thought by some to be due to the strength of the dollar's exchange rate.21


Commodity prices have also had an impact on consumer price inflation. Eurostat shows that the above-target inflation of 2010-11 in the Eurozone was largely due to high energy prices: similarly, the Eurozone deflation of 2014-15 was partly due to the fall in oil and commodity prices at that time.22


The challenge for central banks is therefore to decide when changes in consumer price inflation warrant monetary policy action, and when they don't. The Federal Reserve has been criticised for inflation that is still well below target.23 U.K. policymakers, faced with 3 percent inflation due to recent sterling depreciation, are currently considering whether to raise interest rates in response:24 while Eurozone policymakers, faced with inflation still well below target and a strong euro exchange rate, have decided to keep both interest rates and QE "lower for longer."



Central banks' preferred measure of inflation has remained low and stable since the 2008 financial crisis, raising concerns about wage growth, productivity and the impact of globalization. Meanwhile, consumer price inflation has shown increased volatility, due to large swings in commodity prices and exchange rates. Navigating the uncertainty that this volatility creates in future exchange rates could be a significant challenge for business managers in the months and years to come.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.


1. “Stuck,” Speech given by Andy Haldane, Chief Economist, Bank of England;
2. “Effective Fed Funds Rate,” FRED Economic Data;
3. “The Great Moderation,” Federal Reserve History;
4. “A perspective on nominal interest rates,” Fernando M. Martin, FRED Economic Data;
5. “US broad trade weighted dollar index,” FRED Economic Data;
6. “Sterling monthly average effective exchange rate index”, Office of National Statistics;
7. “China in the WTO: Past, Present and Future,” World Trade Organization;
8. “The Great Moderation,” Federal Reserve History;
9. The Great Recession of 2008-9: Causes, Consequences and Policy Responses, Verick & Islam, Institute for the Study of Labor;
10. And Yet It Moves: Inflation and the Great Recession, Geneva Report on the World Economy;
11. “What is “core” inflation, and why do economists use it instead of overall or general inflation to track changes in the price level?,” Federal Reserve Bank of San Francisco;
12. “Personal Consumption Expenditures Excluding Food and Energy,” FRED Economic Data;
13. “The Relationship between Wage Growth and Inflation,” Federal Reserve Bank of St. Louis;
14. “Flattening of the Phillips Curve: implications for monetary policy,” International Monetary Fund;
15. “UK consumer price inflation,” Office of National Statistics;
16. “Inflation in the Euro Area,” Eurostat;
17. The monetary policy origins of the Eurozone crisis, David Beckworth, Mercatus Center, George Mason University;
18. “Consumer Price Index for All Urban Customers,” FRED Economic Data;
19. And Yet It Moves: Inflation and the Great Recession, Geneva Report on the World Economy;
20. Ibid.
21. “Why is U.S. inflation so low?,” World Economic Forum;
22. “Inflation in the Euro Area,” Eurostat;
23. “The Fed’s problem with inflation,” Bruegel;
24. “UK expected to raise interest rates after inflation hits 3%,” Financial Times;

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