Chinese Inflation And The Impact On The US Economy

The portents from China, on the price front, are ominous. Inflation is rising, as shown in Figure 1:

Figure 1: Year on year PPI inflation (blue) and CPI inflation (red). Source: IMF, International Financial Statistics, updated using news reports.

That being said, I think headlines such as “Inflation in China Poses Big Threat to Global Trade” are a little overstated. From the article:

Because China is now the world’s second largest economy, after the United States, and because the country has been a leading source of global growth during the last two years, money problems here can reverberate from Wal-Mart to Wall Street and the world beyond.

High inflation endangers China’s status as the low-cost workshop for the world. And if the government’s efforts to fight inflation cause the economy to stumble, that will cloud the outlook for international businesses — whether multinationals like General Electric or copper miners in Chile — that have been counting on China for growth.

Pass through into Import Prices or into the Overall Price Level?

I think it’s useful to separate out the effects. First, let’s deal with the possibility of Chinese inflation being imported into the U.S. [1] [2]. Definitely import prices from China are rising, as shown in Figure 2.

Figure 2: Log USD/CNY exchange rate (blue), and Log price of imported goods from People’s Republic of China into the US (red), both rebased to 2005M06=0. A rise in USD/CNY is a depreciation of the US dollar against the Chinese yuan. Dashed line at 2005M06, the month before the CNY exchange regime was modified. Source: St. Louis Fed FREDII, and BLS.

It’s tempting to think that since import prices are going up, that the overall price level will rise. But it’s not clear that this is true. In other words, a rise in the price of imports might be accompanied by a relatively muted increase in the overall price level, so that this induces a relative price change. And this is in fact exactly what we need for global rebalancing (as discussed here).

Figure 3 depicts the contributions of nominal exchange rate appreciation and relative price level changes to real exchange rate appreciation of the Chinese yuan (relative to the rest-of-the-world). Recall:

r ≡ e + pRoW – pCh

Where r is the real value of the Chinese yuan, e is the value of the Chinese yuan in units of foreign currency per Chinese yuan, and pCh is the Chinese CPI. (This definition implies an increase is an appreciation.) Then:

Δ r ≡ Δ e + Δ pRoW – Δ pCh

Using this decomposition, one can identify how much of the real appreciation is due to nominal exchange rate changes and how much to price changes.

Figure 3: Contributions of nominal exchange rate appreciation (red bar) and relative inflation (blue bar) to overall real exchange rate appreciation, on a trade weighted basis, annualized. Source: IMF, International Financial Statistics, and author’s calculations.

Figure 3 indicates that higher Chinese inflation relative to its trading partners has accounted for a greater proportion of the real appreciation of its currency (in trade weighted terms) in recent months. (The graph is a little hard to read, but July, August, and October 2010 can be read as cases where inflation appreciated the currency, while nominal depreciation worked in the opposite direction, so the net effect was real depreciation, of about 13% (m/m annualized).

To the extent that Chinese inflation is understated in the official statistics, then the overall real rate of appreciation is faster (and the height of the blue bar is greater). Note that I’m assuming the CPI is the appropriate deflator; for an alternative view, see [3].

Relative versus General Price Level Effects

I find the ongoing discussion regarding Chinese inflation a little confused. Inflation in China is important for Chinese policy, but exchange rate pass through of Chinese costs to imports into the US appears to be fairly low in recent history (see both Figure 2, and this post regarding econometric estimates), around 0.20. Exchange rate pass through seems to be about double that.

But even then, the change in import prices does not necessarily translate into a price level change. What would be required for that is there be overall upward pressure on prices. To the extent that tremendous excess slack persists in the US economy [4], higher import prices should translate into a relative price, not general price level, change. One study that does not agree with that view is described here. But even if Chinese imports stop applying downward pressure on US prices, it’s not an either/or proposition. It could be relative prices of Chinese imports still rise relative to the general price level. And that is what is necessary for rebalancing the US economy.

On an interesting side note, if Chinese import prices cease to put downward relative price pressure on US import competing goods, then the wage losses that David Autor et al. pointed out will dissipate. This observation highlights the fact that one cannot view accelerating Chinese inflation as an unvarnished negative.

Monetary Policy and the Exchange Rate as an Insulating Variable under Floating

Finally, I think it’s important to recall, amidst the simple-minded angst about loose US monetary policy being exported, and driving up inflation around the world (e.g., here), that the Chinese have accelerating inflation due in part to the fact that they quasi-peg to the US dollar. That is not an immutable. A more autonomous monetary policy and faster exchange rate appreciation could mean lower inflation in China (simple analytics in this post).

Addendum: As for Chinese officials’ views on the appreciation/monetary contraction approaches, see this excerpt from IDEAGlobal Asian Regional Markets (20 April 2011) [not online]:

During the last couple of days, some senior Chinese officials made interesting comments on CNY exchange rate policies. PBoC deputy governor Yi Gang said at the IMF ministerial meeting in Washington that CNY appreciation against USD and other currencies in PBoC’s basket will help China to fight inflation, and that CNY is close to being freely usable, which would meet one main requirement of being included in the SDR. Meanwhile, PBoC Governor Zhou Xiaochuan said that China will continue to reform monetary and financing systems to allow more flexibility in the CNY exchange rate. However, he also said that it is difficult to measure effect of exchange rates in containing inflation from a technical perspective. Yi Gang has been an active proponent of exchange rate policy as a measure to fight inflation, although he suddenly changed his rhetoric and said something like ‘CNY is very close to equilibrium now’ in March. The comments suggest that the idea of exchange rate policy as a tool against inflation might be regaining momentum in China. Yi Gang’s comment on CNY’s usability and Zhou’s comment on more flexibility in CNY confirms the underlying trend of opening up CNY and suggests that the Chinese policy makers feel the need to speed up the process. …