When History Does Not Repeat: Keys to Understanding Moderate Currency Pass Through

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“There are four types of countries: developed, developing, Japan and Argentina” . This phrase by Simon Kuznets has often been used to illustrate the complexity of the behavior of the Argentine economy, even more so for those who live abroad . One of the elements that best reflects this particularity is the so-called “cepo cambiario”, a measure that any Argentine citizen could explain, but which is extremely difficult to understand for those who are not from the country.

The " cepo " is actually a regulation that practically prohibits the purchase of dollars by individuals and businesses . It has been established many times in recent history, mainly to avoid a sharp devaluation of the exchange rate, due to the lack of reserves of the Central Bank . The problem with this measure is that it creates a parallel market with a higher price, which ends up becoming the real reference for the economy, generating serious problems for both inflation and economic activity.

The "cepo" was imposed by the Macri government in 2019 , during a currency crisis following a heavy defeat in the presidential elections, and remained in place throughout the government of Alberto Fernández. Its elimination had been one of the main promises of the electoral campaign of Milei , who once in government, however, adopted a much more cautious approach, given the evident difficulties of the Argentine economy (high inflation and a Central Bank without reserves).

Thus, only in mid-April of this year and after having signed a new agreement with the IMF, the government announced a new currency regime , eliminating most of the regulations and allowing the exchange rate to float freely, within fluctuation bands defined by the Central Bank (this regime change has been discussed in depth in a previous article).

However, the most interesting aspect is that a few weeks ago the May inflation data was published, showing a significant reduction compared to April ( from 2.8% to 1.5% monthly). In other words, after the change of currency regime, inflation not only did not increase, but decreased . The government deserves credit, since most economists had expected a much more significant impact on prices. How do you explain this phenomenon?

It is very common to reason on the basis of previous experiences and project that something similar will happen . This exercise is valid only if the context is similar; otherwise, the prediction will almost certainly be wrong. For example, if I put some water on to heat, I could predict that at 100° it will boil. But this would be wrong if I were at 3,000 meters above sea level (in this case, water boils at 90°, since the boiling point depends on atmospheric pressure, which decreases with altitude).

In economics, this type of error is common , and in particular, it occurred in the reasoning that most economists – including myself – used to argue that removing the price cap would have a more significant impact on prices.

The extent to which exchange rate increases are passed through to prices (known as pass through) is a widely studied topic in economics. In recent years, a consensus has been reached in the literature regarding the non-linearity of this phenomenon. This means that the proportion of pass-through to prices is not always the same, but depends on a series of variables related to the macroeconomic context.

The most relevant variable is undoubtedly the level of inflation at the time of the devaluation. In economies with low and stable inflation, businesses and consumers expect this stability to last over time – both because of previous experience and because of trust in the work of the Central Bank. In these cases, expectations are said to be “anchored”, and this leads to a lower pass-through to prices after a devaluation. On the contrary, in contexts of high inflation, the pass-through to prices is much higher, because businesses reason in the opposite way (“I increase my prices because inflation will certainly rise”).

Related to this, the frequency with which prices adjust also changes. In any economy, prices are linked through a network of “indexed contracts” that are periodically updated based on what happens to other prices in the economy. Obvious examples are rent or wage agreements (formal contracts), or even the increases that a firm applies to its products (informal contracts). This process actually involves all prices, because none can lag far behind general inflation. Consequently, the higher the level of inflation, the more frequent the adjustments of prices (and wages). Firms and workers have perfected the process of negotiating and updating prices and wages, making economies with high inflation more sensitive to potentially inflationary events (“cautionary increase”).

Two other relevant factors in estimating the pass-through are the economic situation (the lower the firms' sales, the less they are able to pass on exchange rate increases to prices) and the degree of openness to imports (greater competition leads to less pass-through to prices).

Now we can explain why the pass through was low. Actually, not that low, because the first observation to make is that March inflation was atypically high (consulting firms were expecting monthly inflation of 2.6%, i.e. a slight increase due to seasonal factors).

Inflation (in % monthly)

This is explained by the high uncertainty and volatility of the exchange rate generated by the government through the continuous rethinking in the negotiation – and communication – of the agreement with the IMF and the new currency regime. As previously mentioned, Argentine companies are very used to increasing prices for precautionary reasons , trying to anticipate a potential general increase in prices. Therefore, the high inflation in March is largely explained by this reason.

This also helps to understand why, after the initial 10% increase in the exchange rate in the first few days after the change in the currency regime, inflation subsequently declined. The reason was precisely that many companies had already increased their prices before the official devaluation ; it is even likely that several companies increased their prices more than necessary, assuming that the official exchange rate – the light blue line in the graph below – would rise to the level of the financial exchange rate – the grey line – at that time ($1,335/USD). In reality, and as can be seen below, the financial dollar fell by 13% (to $1,157/USD).

Official, Financial and Currency Bands Dollar

However, this is not enough to explain the low pass through; there are other elements that contributed to this result. First, the devaluation occurred in a context of falling inflation (albeit with ups and downs and starting from very high levels) and with a slightly restrictive monetary policy . Added to this is that the new exchange rate regime has practically eliminated the difference between the official rate and the financial rate (which is what really matters for the functioning of the macroeconomy, and not so much the discussion on the total elimination or not of the "cepo"), moving to a flexible exchange rate regime contained by currency bands. All this has helped to better stabilize inflationary expectations and reduce exchange rate volatility.

Second, although economic activity is recovering, mass consumption is not picking up and remains below the levels of late 2023. As we have seen, this factor has helped moderate the ability of companies (especially those related to mass consumption goods) to pass on the increase in the exchange rate to prices.

Third, despite the libertarian narrative (according to which the State should never intervene in agreements between private individuals), the government has intervened strongly in wage negotiations , blocking agreements reached between unions and employers' associations that exceeded the established ceiling of 1% per month. This obviously helps to curb inflation, but at the cost of reducing workers' purchasing power.

Finally, and related to the previous point, the government also blocked increases in fuel prices and public service tariffs (something it had always publicly criticized under the previous administration), with the aim of contributing to the reduction of inflation.

In short, the low price pass-through of the currency jump is explained by the context and government intervention : preemptive price increases for hedging purposes, more stable expectations thanks to the recent drop in inflation, still weak consumption that limits the ability to raise prices, a restrictive monetary policy, a more stable exchange rate thanks to the new regime and – although it contradicts the libertarian narrative – strong state interference in wage negotiations and regulated prices. As we have argued since day one, to understand this government you must not pay attention to what it says, but to what it does .

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