The term ‘imported inflation’ refers to a situation where a country is experiencing higher costs for the goods and services that it buys from other countries. For large economies like the United States this has relatively little effect, but smaller economies tend to trade much larger proportions of their GDP, making imported inflation much more serious.
Domestic price inflation i.e., the steady rise in the general price level of all goods and services, imported or not, is influenced by many factors. Not all of those factors relate to circumstances within the domestic economy, there are many outside forces that also play a significant role.
In this article I will explain the concept of imported inflation. In particular, I will focus on how a strong US dollar works to export inflation from the US to other countries around the world.
In the graph below, an economy starting at point A has a stable 5% unemployment rate, and a stable 2% inflation rate. Unfortunately, it experiences imported inflation via a fall in the value of the domestic currency relative to other currencies. As a result, imported goods and raw materials become more expensive, which in turn causes an increase in inflationary expectations going forward.
This is represented in the graph via a shift in the Phillips curve from PC to PC', and the economy moves to point B with a higher inflation rate at around 4%. For a deeper explanation of this process, see my article about:
At point B the government and central bank have a difficult problem to solve; if they do nothing then they will face a permanently higher inflation rate. Alternatively, if they act to reduce inflation, then they will likely cause a recession and rising unemployment. This is depicted by the move from point B to point C in the graph.
Recession, and rising unemployment (to around 8% in the graph) may be the only way to get inflationary pressures under control and bring inflationary expectations back down to their original level. This would allow the economy to recover and move back to point A but, in the meantime, a great deal of economic hardship is suffered.
Several factors cause imported inflation:
Central banks play a crucial role in managing imported inflation and maintaining price stability in an economy. Most importantly, they use interest rates i.e., monetary policy, to manage liquidity in the financial system. By adjusting interest rates, central banks can influence borrowing costs, consumer spending, and investment levels, thereby impacting inflationary pressures.
In the context of imported inflation, they also consider the impact of currency exchange rate fluctuations on overall inflation. If the domestic currency depreciates significantly, leading to higher imported inflation, central banks may need to adopt a tighter monetary policy stance to curb inflationary pressures. This can involve raising interest rates or reducing liquidity in the financial system.
Conversely, if the domestic currency appreciates, reducing inflationary pressures, central banks may adopt a more accommodative monetary policy stance to support economic growth. This can involve lowering interest rates or injecting liquidity into the financial system to stimulate borrowing and spending.
As the global reserve currency, the US Dollar plays a pivotal role in international trade and finance. When the US Dollar strengthens against other currencies, it can have far-reaching effects on the world economy, one of which is the way in which it exports inflation to other countries. The main reason for this is because of exchange rate movements.
With most internationally traded products and commodities priced in terms of US dollars, a stronger dollar means that consumers outside the US will have to pay higher prices in terms of their domestic currencies. In other words, the exchange rate of their currencies will fall against the dollar, thereby contributing to international inflationary pressures.
There are two additional forces that influence this sort of inflation exporting, and they both relate to the flow of international investment funds. However, these two are competing forces meaning that, depending on which force dominates, the balance on exported inflation may be positive or negative:
The dominant overall effect is the exchange rate effect, and at times when international investors are less optimistic about the global economic environment, it is likely that the demand for safe-haven Us assets will dominate the appetite of US investors to buy the cut-price assets available in other countries. In these circumstances the effect of US exported inflation will be particularly significant.
When a strong US Dollar exports inflation to other countries, it presents several challenges:
The depreciation of the Brazilian real from 2010 to 2016 against major currencies, such as the US dollar, led to higher prices for imported goods. Additionally, supply disruptions, such as droughts affecting agricultural production, have further contributed to imported inflation since more expensive food imports had to replace domestic food products.
To manage the problem, the Central Bank of Brazil implemented various monetary policies. In particular, interest rates were increased to curb inflationary pressures and stabilize the currency. Additionally, the government implemented measures to promote local production and reduce reliance on imports, such as tax incentives for domestic industries.
Inflation, which had peaked at around 11% in 2016, had been reduced to around 2.5% by 2018. However, unemployment rose from a low of around 6.8% in 2014, to a high of almost 13% in 2017.
Imported inflation is a critical factor influencing the economies of countries highly dependent on international trade. A strong US Dollar can export inflation to other nations through exchange rate movements, commodity pricing, and shifts in capital flows.
As global economies become increasingly interconnected, government and central bank policymakers need to account for the impact of exchange rate fluctuations, commodity prices, trade policies, global supply-chains, and transportation costs on domestic price levels.
Of particular importance is the exchange rate of the global reserve currency, the US dollar, because US exported inflation can be significant, and particularly so in smaller countries when investors are fearful of recession. Imported inflation adds to domestic price inflation, and controlling it can be very difficult because the necessary measures can cause recession.