The exchange rate is one factor in inflation, but not the biggest.
A weak US dollar, a strong renminbi and higher inflation recently may have led some to question again the appropriateness of retaining the link between the Hong Kong dollar and the US dollar. It is true that currency weakness contributes to domestic inflation to a greater degree in Hong Kong, with its highly externally oriented economy which imports almost all its daily necessities, than in the less externally oriented economies. But it is important to understand how sensitive to exchange-rate changes our domestic inflation rate actually is.
There are well established methods for examining what is called "exchange rate pass-through to domestic inflation". While it is probably not necessary to go into details, this is a subject that is on the research agenda of almost all central banks, including the HKMA even though our monetary objective is exchange-rate rather than price stability. The gist of our findings is that the exchange rate pass-through to domestic prices is about 0.1% in the short run and about 0.2% in the medium run. This means that a one-percent depreciation of the nominal effective exchange rate (NEER) of the Hong Kong dollar would lead to an increase of 0.1% in domestic prices in the short run and 0.2% in the medium run. Given the focus on the weakness of the US dollar, another way to look at this is that a 10% depreciation of the US dollar against all currencies other than the Hong Kong dollar would cause domestic prices in Hong Kong to increase by 0.82% in the short run and 1.61% in the medium run.
These numbers do not seem very high, at least relative to the expected rate of inflation now prevailing in Hong Kong, although they are considerably higher than those for the less externally oriented economies. For example, the exchange rate pass-through to domestic prices in the medium run is only about 0.01% in the US and 0.17% on average in the Organisation for Economic Co-operation and Development economies. Our research also found that unit labour cost is a more important determinant of inflation in Hong Kong than import prices, which are influenced by the exchange rate and, of course, domestic inflation in our import markets. In other words, even for a very externally oriented economy like Hong Kong, domestic factors still dominate inflation dynamics in the medium run.
However, this is not to say that the exchange rate does not matter. Indeed, the 16% depreciation of the NEER of the Hong Kong dollar between 2002 and 2007 was responsible for pushing up the average annual inflation rate by about 0.4 percentage points during the period. In 2007, the estimated contribution of exchange-rate depreciation was 0.6 percentage points, or about 20% of the underlying inflation in that year. But obviously it is necessary to put the significance of the exchange rate in its proper context, supported by empirical research, when commenting on the subject, particularly when discussing possible remedies.
Given that unit labour cost is the more important contributor, effective remedies should focus on improving and sustaining growth of labour productivity. There has been remarkable growth in labour productivity in recent years, perhaps as a result of advances in information technology, leading to a decline in unit labour cost and exerting a strong dampening effect on domestic inflation. But the strong and sustained economic recovery since 2003, which has led to a persistent decline in the unemployment rate to near 10-year lows, has in the past year or so reversed the downward trend in unit labour cost. I believe this is an important reason for the upturn of domestic inflation in recent months, as we have seen fairly large increases in pay in many sectors. This coincided with significantly higher inflation in our import markets. The weaker US dollar, while undoubtedly a factor, has perhaps attracted much greater attention than other factors.
Joseph Yam
3 April 2008
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