Exchange rate pass-through and inflation targeting regime under energy price shocks

The global surge in energy costs poses a significant obstacle for the attainment of price stability by the central banks across the world. This obstacle is further magnified for the economies that adopt an inflation-targeting framework and a flexible exchange rate regime. To overcome this challenge, our study attempts to answer whether inflation targeting can achieve price stability if an exchange rate pass-through exists, especially in the presence of energy price shocks. The study uses secondary data from twenty-one inflation-targeting economies for the period 1997-2020 and applies the non-linear autoregressive distributive lag (NARDL) model to test the hypotheses empirically, considering the possible asymmetries. The results confirm that exchange rate depreciation increases domestic price levels, while exchange rate appreciation reduces them in the long run. The study also finds that rising energy prices contribute to higher inflation in inflation-targeting economies. These findings suggest that inflation-targeting economies face a serious challenge in maintaining their core price stability goal due to exchange rate pass-through especially during energy price shocks. The results invite authorities of IT economies to re-evaluate their policy framework that conveniently ignores exchange rate pass-through by requiring a mandatory floating exchange rate regime.