Forecasting industry-level CPI and PPI inflation: does exchange rate pass-through matter?

We examine whether industry-level forecasts of CPI and PPI inflation can be improved when we use the “exchange rate pass-through” effect, that is, when we account for the variability of the exchange rate and import prices. We build a forecasting model based on a two or three equation system involving CPI and PPI inflation where the effects of the exchange rate and import prices are explicitly taken into account. This setup also incorporates their dynamics, lagged correlations and appropriate restrictions suggested by economic theory. We compare the forecasting performance of our model with a variety of unrestricted univariate, multivariate time series models with and without standard control variables for inflation, like interest rates and unemployment. Our results suggest that improvements on the forecast accuracy can be effected when one takes into account the possible pass-through effects of exchange rates and import prices on CPI and PPI inflation.