Energy shocks drive euro area inflation volatility

A new DNB working paper finds that imported energy prices and exchange rates significantly influence euro area inflation. Energy price shocks account for most of the post-pandemic inflation surge.

The energy-exchange rate nexus

Researchers developed and estimated an open economy DSGE model for the euro area, integrating imported energy priced in foreign currency into both consumption and production.

This framework reveals that global energy prices and the exchange rate jointly determine domestic inflation.

The study attributes the bulk of short-run volatility in headline euro area inflation to energy and exchange-rate disturbances, with energy price shocks primarily driving the post-pandemic surge.

Due to poor substitutability between energy and non-energy goods, an adverse energy price shock increases import values, leading to a deteriorating trade balance and a depreciating real exchange rate through net-foreign-asset and UIP channels.

This complex interaction highlights the profound impact of external energy dynamics on the euro area's economic stability and price levels, underscoring the need for a comprehensive understanding of these transmission mechanisms in monetary policy formulation.

Monetary policy's exchange rate leverage

The paper demonstrates that the exchange-rate channel significantly strengthens monetary transmission, improving the short-run inflation-output trade-off compared to a non-energy economy.

Optimal policy can strategically exploit this channel, rather than simply 'looking through' energy price shocks.

However, the case for such a 'look through' approach becomes stronger when the central bank prioritizes output gap stabilization and when prices exhibit greater stickiness.

The research identifies three key contributions: quantifying energy price shock impact, detailing the open economy dimension's role in monetary policy transmission, and characterizing optimal policy-rate paths against historical rules.

This nuanced understanding of the exchange rate's role is crucial for central banks navigating energy-driven inflationary episodes.

Beyond conventional wisdom

This research critically refines the conventional wisdom on central bank responses to energy shocks in open economies.

It demonstrates that a nuanced approach, rather than a blanket 'look through' policy, is essential for an energy-dependent euro area.

The findings challenge policymakers to re-evaluate their trade-offs between inflation and output stabilization, especially when considering price stickiness and the weight assigned to output stability.