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, in logs:

r ≡ e + pRoW – pCh

Where r is the log 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 log 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 interesteing 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. …

Update, 11:23am 4/22: From Reuters:

The yuan ended at a fresh record high on Friday as the central bank continued to allow the currency to rise to help fight imported inflation, but onshore traders remained convinced it would not resort to any one-off revaluation despite rumors overseas.

The People’s Bank of China (PBOC) has set repeated record highs for the yuan’s daily mid-point over the last several weeks, engineering an accelerated rise against the dollar that means it has now gained nearly 5 percent since it was depegged last June.

Those recent gains, together with comments this week by PBOC adviser Xia Bin that he would not rule out another one-off revaluation, have sparked talk among forex traders, especially those offshore, that such a move could be imminent.

But a number of reasons argue against such a possibility.

Policymakers as senior as Premier Wen Jiabao have repeatedly ruled out the possibility of another one-off revaluation, meaning any surprise would put the government’s credibility at risk and could spark a backlash from the politically strong export sector.

19 thoughts on “Chinese Inflation and the Impact on the US Economy

  1. Nemesis

    Combine pass-through effects of Chinese (US firms’ subsidiaries’) import prices AND the effect of the rising price of oil on US oil consumption as a share of private GDP, and the private US economy is already on a trajectory toward contraction later in ’11.
    Annualized q-q and yoy profit margins will plunge hereafter long before capacity gets tight and labor market growth begins to accelerate.
    Similarly, the avg. 10-yr. real per capita private GDP trajectory will contract further hereafter, ensuring that real private per capita GDP is no longer possible.
    Finally, as of ’09-’10, China’s bank lending and money supply growth to GDP reached the terminal exponential order of magnitude differential growth, after which bank lending will contract at least 30% or more. At the cap rate, the Chinese banking system’s collapse will dwarf that of Japan and that of the US so far (only one-third of the way through our debt deflation regime).
    China’s massive fixed investment and credit bubble to GDP (largest in history) and accelerating price inflation (oil related) will eventually be deflationary for the global economy.
    China is a four-letter word: SELL.

  2. Ivars

    China has 3 level priorities:
    1) Maintain the rule of communist party
    2) Maintain sovereignity over all its parts
    3) Maintain economic development speed
    Which of these will be sacrificed if things get hard in China? Start from the bottom. Nationalization of private industries and businesses, including foreign, redistribution of wealth, elimination of middle class.
    The rest of the problems which will arise with China slowing down will be solved internally by usual communist methods.
    Wellfare of the people has never come even close to the top of priorities. Its improvement is only a temporary side effect of industrialization of China and stealing of technologies and knowhow, scientific knowledge from the West.
    So, not according to Tyler, China will be perfectly consistent in solving their problems by eliminating them in a sequence that satisfies their priorities . No people, no problem. Neo-Stalinism. That will give them an edge over the weakened West for at least 40-50 years.
    By taking hard line stance soon, China will win superpower status very soon, based on military might and consolidated command structure.
    And they are not the first in communist history to win over the West with similar methods in history. See Soviet Union, 1928-1938. The end of New Economic Policy and start of serious militarization. Finalized in 1949 with Soviet Union as one of worlds 2 superpowers. Started from scratch after 1929 crisis in the West.

  3. Steven Kopits

    I think, Menzie, these outcomes are consistent with your analysis of a couple of months ago.
    And, yes, as China becomes more wealthy, it will draw in more imports–good for US workers–and compete more effectively with US high end labor like finance, dampening that top 1% of earners get it all effect. Top i-banking jobs are in Singapore, Hong Kong now.

  4. Ricardo

    Menzie wrote:
    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).
    Exactly! The question is first, as you note in your linked post, do the Chinese value exports more than domestic inflation, but second, should the Chinese value exports more than domestic inflation. So far the Chinese have chosen to import US inflation rather than hinder exports. This appears to be one of the driving forces in Chinese growth. But as Chinese growth moves their economy forward will their international trade position allow them to go it alone with the RMB? As your quote of the Chinese officials notes they seem to be moving in that direction.
    So I would caution Mr. Timothy Geithner to be careful what he wishes for. If the Chinese do engage in a serious revaluation of the RMB what will be the impact on the dollar?

  5. The Rage

    Yes Ivars but you are forgetting the SEM and further enhanced during the Stalin was created by the capitalists and the Corps financed by Wall Street. It is why the “Soviet Union” was called Wall Street’s utopian hoax and why the post-cold war era militarization of the US was necessary to defeat it when Stalin “re-patrioted” the SEM under Russia control.
    The whole model as being called “communism” was actually in Marxist terminology, the final stage of capitalism. A forced retribution of capital.Fuedalism in a nutshell.
    These Fuedal powers in China do not have to worry about the middle class anymore than American capitlists have to over here, because THEY are the middle class.

  6. Also sprach Analyst

    Historically the pass-through might be minimal because an appreciating currency helps them to keep price level low. But one may want to consider the fact that the trend of rising income, especially as China now have an ageing country, which will mean the era of cheap labour is probably gone.

  7. Ricardo

    Also sprach Analyst,
    China has strong employment along the coasts and in the major cities but, taking the country as a whole, it still has a huge unemployment/under-employment problem. There may be many problems China will face in the future but the lack of cheap labor is not one of them.

  8. tj

    The recent lesson from around the world is that higher food and energy prices combined with an oppressive government are the indgredients for demonstrations at best, and revolt at worst. You can bet that China is very sensitive to events in the Middle East and will do whatever it takes to keep inflation in check, even at the expense of a more rapid appreciation of the CNY and/or higher reserve requirements for Chinese lenders.
    Could get interesting for commodity traders.

  9. David Pearson

    The second order effect of a Chinese de-pegging is higher imported inflation for us. This is not necessarily a “one time” event. To the extent that the Fed accommodates the import price shock, it will be passed through, which reduces our real interest rates (all else equal), produces “easier” policy, and creates pressure for further Yuan appreciation. Like Latin currencies in the 90’s, there is a constant dynamic towards devaluation created by monetary policy. In those cases, the serial devaluation was only arrested through a large dose of austerity. Yes, wages rose, but this was a symptom — after all, workers had to eat, and food prices were always rising.
    One also have to take into account the impact of de-pegging on our nominal term interest rates. Pull the Fed and Chinese Treasury demand, and you will need positive real term rates to entice private savers to buy — Japan always provided these. Needless to say, the economy does not need higher real term rates right now.
    BTW, don’t most economists believe the Phillips Curve holds only in the short term? At what point do we enter the “long term”?

  10. Bryce

    Thanks for an interesting posts & lots of good comments. I think this is a pretty important subject.
    I concur with Nemesis that China is in a Brobdingnagian credit bubble, & that their need to fight domestic inflation will require their total depegging & trigger a huge bust via higher interest rates & the need to raise their export prices. Their Asian competitors such as India are in roughly the same place & will be affected by China’s lead.
    Asians ceasing to buy US & Euro debt [as they have in the past, ~half with freshly created Yuan, Yen, etc.] will commence a secular, global increase in long-term interest rates, a particularly significant event in view of the swollen & swelling debt in Europe, Japan, the US, et al.

  11. Bryce

    Menzie: “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”
    You are generally right. The Chinese would not have the inflation & problems ahead of them now had they had an autonomous, restrained monetary policy. (Nor would they have grown at the unrealistic boom rates. Nor would there be all the ‘imbalances’ you cite.)
    Yet aren’t you being a bit cavalier referring to “simple-minded angst about loose US monetary policy being exported”? It is easy to forget that the US$ is THE world reserve currency. The autonomy & foresight to resist US inflating isn’t common in the politicians who ultimately run central banks.

  12. David Pearson

    It strikes me that, in the early-to-mid 2000’s, the simple-minded were anxious about the effects of monetary policy on the housing bubble, leverage, and systemic risk. If only they had looked at things in static terms, they would have realized how small and contained that sub-prime problem really was…

  13. DFC

    The strategical approach of China is in the longterm, it is not based in the current situation, as the western leaderships. In the roots of their policy is the Deng’s priority to achieve superiority in technological terms, because at the end the only valid equation in political, economic and military terms is: power = technology
    In the recent history of China, from the Opium’s wars, to the Boxer revolts, the japanese invasions, Corea, etc…China was defeated only because the lack of modern technology, and these are hard lessons chinese leaders have learnt, and Deng was fully aware of that
    So the chinese leadership will maintain the status of China as “paradise for the manufacturing investment” in order to get all the advanced technology available, with the goal to have the know-how and the people ready to develope it, which is the important side of the technology (software and brains are more important than hardware itself)
    China has 1 billion people more to sustain the cheap labour cost demanded by the multinational companies, so no problem with lack of “unemployment army”, they are enough to destroy all the manufacturing capacity remaining in the western countries. MNC will send all of this technology to China

  14. ivars

    If chinese revalue yuan,QE3 is not coming,but recession and increased debt is a sure thing in the USA , as Chinese imports add inflation to oil and food pressure.
    Bernankes April 27 may contain unexpected answers to “unexpected” events-silver crash with some bailout,yuan,what else.Long holidays are great for suprises.

  15. Menzie Chinn

    Bryce and David Pearson: I don’t know, but I was worrying asset booms, overborrowing, etc., in mid-2005 (and I put it down in actual paper!). Anyway, by simple-minded, I mean taking the US monetary policy to foreign monetary policy link as exogenously given. Counties face a trilemma in making choices about trading off autonomy along different policy dimensions.

  16. David Pearson

    Yes, the peg is not exogenously given.
    The Chinese face a choice between a larger export base and a larger consumption base. The choose the former because the latter caused a dangerous inflationary episode in the 1990’s. So, a revaluation would lead to a consumption boom, which in turn would lead to higher domestic inflation. Rather than dampening global inflation, this might exacerbate it, particularly when combined with further Fed accommodation. You could argue that a consumption boom today would have less effect on China inflation; or that a reval would not cause a consumption boom. I would be interested to hear both arguments.
    The Bretton Woods II regime has dampened inflation for years. The problem is that its usefulness in that respect is now expiring. That does not mean, however, that abandoning Bretton Woods II won’t cause yet more inflation.

  17. Shanghai Bob

    The 包子 in my street just went from 1RMB to 1.2RMB, sweet mother of god…
    @The guys who still use ‘China’ and ‘Communism’ in one sentence: stop doing that.
    @The rest: the direction seems pretty clear: less reliance on export, more emphasis on domestic markets, steady RMB appreciation till equilibrium, meeting the SDR requirements, then some years of politicing and gaining power inside the IMF, and eventually getting their strategic stake in the SDR. Meanwhile, the balancing act between inflation, growth and unemployment shall continue as long as farmers farm, birds chirp and cows do that moo-thing.

  18. Ivars

    @The guys who still use ‘China’ and ‘Communism’ in one sentence: stop doing that.
    Never. Do not forget the priorities of Chinese rulers:
    1) Party rule
    2) Sovereignity over whole China
    3) economic development.
    In that order, not reverse!
    “Communism” may be is not the right word if You try to put some anachronic dictionary meaning to it, I should have said “Party”, “totalitarian” instead ,and “neo-stalinism” for the coming policies it will embrace.
    IMF can not be an aim for Chinese, as IMF itself may have huge problems once the USA ( after Greece, Ireland, who knows who else) defaults on its debt in 2-3 years from now.
    Chinese will have to devise a policy to survive without the IMF, SDR, and USA and Eurozone as its huge export markets.
    My bet is on nationalization and liquidation of last 30 years “excesses”.
    MNC will still supply them with technolgy as they will be in dire need for Chinese sales. At least for some time after neo-stalinism is reinstalled. Until foreign enterprises are nationalized as well.
    There is no better way to keep exports cheep as to nationalize enterprises and fix the sales prices and wages, eliminating owner profit and investment. Communists ( OK, social engineers of Chinese Politbureau) have done it numerous times in history in all countries they rules, never hesitated or regretted it.
    To keep people employed, focus on internal demand- MILITARIZATION. For that to pay off, look a EXPANSION in some point in future ( Taiwan goes first).

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