Monetary Policy Credibility and the Exchange Rate Pass-Through to Inflation

Abstract

We estimate counterfactual VAR models to determine whether monetary policy credibility channel impacts the response of inflation to exchange rate depreciation shocks. We shut-off the policy credibility indicator channel to determine the counterfactual consumer price inflation response to exchange rate depreciation shock. Evidence shows that the counterfactual consumer price inflation rises more than the actual reaction. This suggests that high monetary policy credibility weakens the size of exchange rate pass-through to inflation. The monetary policy credibility has bigger dampening effects when inflation exceeds 6% than using the 3–6% band or below 6%. This implies the threat of elevated upside risk, from the exchange rate depreciation shock in influencing inflation developments, may not be that elevated if the role of the monetary policy credibility is considered in the policy discussion. The role of credibility of policy conduct on the exchange rate pass-through to inflation is therefore crucial in the minimisation of exchange rate pass-through to inflation.