The strength of the dollar is certainly something we take account of in deciding on monetary policy. I agree with you, net exports have declined. It's been a drag on the economy, and for that reason, does factor into our thinking. It's one of the reasons we think that the so-called neutral level of the fed funds rate is low at the moment.

But remember that in spite of that drag, and the impact it's having on manufacturing, the economy has continued to create jobs at a pace of 220,000 or more a month. And we can't just look at sectoral impacts, we have to look at the overall performance of the labor market. But certainly, the dollar and the drag that it implies, it is a symptom, and in part, a signal of the strength of the U.S. economy in comparison with many others.

The empirical evidence also indicates that pass-through from exchange rates to import prices is low and has declined markedly over the past two decades. This evidence suggests that there may be a weaker relationship between exchange rate fluctuations and nominal demand than prevailed in the past, which may make it easier for monetary policy to stabilize inflation and real activity. Nevertheless, exchange rate fluctuations can still have an effect on inflation and economic activity; hence, monetary policy must continue to take these fluctuations into account to ensure that inflation expectations remain well anchored and that fluctuations in economic activity are minimized.

In contrast, unpublished empirical work by the staff at the Federal Reserve Board suggests that, once we take the rising share of imports into account, the influence of import prices on core inflation in the United States has not changed much in the context of reduced-form forecasting models.⁶ At the same time, the influence of exchange rate movements on import prices--the so-called pass-through effect--may have fallen substantially, at least according to some studies.

After adjusting for the rising share of imports in domestic price increases, we see little indication of a reduction in the effect of import prices on U.S. inflation. We have some evidence, however, of a reduced effect of exchange rates on import prices (Ihrig, Marazzi, and Rothenberg, 2006), although this result may be sensitive to specification (Thomas and Marquez, 2006).

However, the conclusion that inflation is determined only by monetary policy choices need not hold in the short-to-medium run. In the shorter term, central banks do not usually offset completely the effects of shocks to supply or prices--of which a change in the relative price of imports is an example--in part because any monetary action made in response will take time to be effective.

Rogoff (2003) provides an alternative theory of how globalization may affect the central bank’s inflation objective. He argues that deregulation and international integration have led to more flexible prices, so that any attempt by a central bank to stimulate the real economy by allowing inflation to rise unexpectedly will be less effective than it would have been in the past. Because central banks have less incentive to create unexpected inflation, their promises to keep inflation low are more credible, which in turn reduces the cost of keeping inflation low. Accordingly, in Rogoff’s analysis, globalization has led monetary authorities to maintain lower long-term inflation rates. A criticism of this story is that it implies that the Phillips curve is steeper today than in the past (that is, that inflation is more sensitive to slack in the economy), a prediction that does not accord with most empirical studies.

[I]mported goods make up only part of what people consume, and so the effect on overall inflation is less than the deceleration in the prices of imports alone. Typical estimates of the short-term effect on the overall inflation rate of less-rapid increases in the prices of imports stemming from trade with China are in the neighborhood of 0.1 percent or less per year--a discernable but certainly not a large effect.

[I]t is likely that {passthrough} has played at least some role in recent core inflation movements. Now that energy prices have fallen a fair bit from recent highs and are expected by futures markets to remain at those lower levels, this upward pressure on core inflation is likely to dissipate and could even turn into modest downward pressure at some point.

But let me note that we shouldn't exaggerate the importance of this point. Recent analysis suggests that the extent of passthrough for any given rise in energy prices has been lower in the past twenty-five years than it was back in the 1970s.1 For a specific example, consider airfares, which have increased markedly over the past year. Considering that jet fuel accounts for one-eighth to one-fourth of airlines' operating costs, it would make sense to think they have passed through higher fuel prices into airfare increases. However, some simple calculations show that the cost increases from rising jet fuel are likely insufficient to explain more than a portion of the airfare increases, and that higher load factors are likely to be part of the explanation.

[R]ecent research suggests that the extent of passthrough for any given rise in energy prices has been lower in the past twenty-five years than it was back in the 1970s. However, it seems likely that energy passthrough probably has played at least some role in recent core inflation movements. In this case, if energy prices level out, as expected by futures markets, this upward pressure on core inflation is likely to dissipate at some point, and this would help on the inflation front.

All told, increases in energy prices over the past couple of years probably added about 1/2 percentage point to core inflation in 2005, and the lagged pass-through of past increases in energy prices appears likely to add roughly the same amount this year, provided that energy prices do not rise significantly further.

All told, increases in energy prices over the past couple of years probably added about 1/2 percentage point to core inflation in 2005, and the lagged pass-through of past increases in energy prices appears likely to add roughly the same amount this year, provided that energy prices do not rise significantly further.

Over time, however, foreign producers seem to be absorbing a greater share of the impact of a falling dollar in their profit margins rather than passing it on fully in their prices, and I expect the drop in the dollar to have only a modest effect on U.S. inflation.