What the renminbi means for American inflation
Raphael Auer
21 February 2011
This column says that low US inflation over the last 15 years is partly attributable to cheap Chinese imports. It argues that if the US trade deficit is reduced – via either Chinese inflation or a nominal appreciation of the renminbi – this disinflationary effect will be reduced. It says that the resulting inflationary impulse could be severe.
China’s recent inflation is turning heads (Raede and Volz 2011, Cavallo and Díaz 2011). At first thought, the recent rise of inflation in China seems to be reassuring news for US policymakers concerned with the trade deficit. On the one hand, price increases in China make US firms more competitive, and on the other, high inflation may also goad China into letting the renminbi appreciate at an accelerated pace to lower the cost of imported goods. Thoughts along these lines have lead treasury secretary Timothy Geithner to note that current economic developments “will bring about the necessary adjustment in exchange rates” without any need for further intervention by policymakers.
What has not entered this policy discussion, however, is that the trade deficit with China arose for a reason, namely that Chinese goods are dirt cheap. In fact, the increasing importance of cheap imports was a major contributing factor to the low-inflation environment of the last decade (see on this site Auer and Fischer 2008).
If the US trade deficit is reduced via either Chinese inflation or a nominal appreciation of the renminbi, the disinflationary effect of cheap Chinese imports will be reversed. Given that nearly a sixth of all US consumption of manufactured goods is actually made in China, any real appreciation would have a substantial direct impact on inflation due to the weight of Chinese goods in America's inflation indexes. In a recent study (Auer 2011), I document that such an appreciation might also substantially alter the competitive environment on many US markets and consequently lead to widespread inflationary dynamics.
The study examines the 2005 to 2008 period when the Chinese government let the renminbi appreciate by a combined 17% against the dollar. Matching this appreciation with sectoral US price data, it documents how a higher renminbi translates into higher import prices and, in turn, how this affects the prices that domestic firms charge. Overall, the results suggest that in the covered sectors, a 1% appreciation of the renminbi causes American producer prices to increase by a little over half a percentage point.
Figure 1. A 25% renminbi appreciation and US producer price inflation
Figure 1 uses these findings to simulate the effect of a renminbi appreciation on producer price inflation. In both scenarios the yuan appreciates by 25%, with the appreciation being spread over either 10 or 25 months. For example, these simulations suggests that a 25% appreciation spread over 10 months is equivalent to a temporary 5 percentage points (!) shock on US producer prices.
Inflation in China will have enormous consequences for the course of US inflation. The key question is, of course, what can one do about it? Many argue not much – a real appreciation in China will sooner or later feed into American inflation, in one of two ways:
- First, it can be achieved via a controlled nominal appreciation of the renminbi.
- Second, in the absence of such an appreciation it will come via inflation in China, since – as Paul Krugman bluntly puts it – inflation is merely “the market’s way of undoing currency manipulation”.
However, this does not imply that there are no policy options. While the spillover of Chinese inflation into US prices is unavoidable, its timing can be controlled via the timing of the appreciation. US inflation is still low at the current juncture; the core CPI gained a muted 0.8% during 2010 and the ample excess capacity (recently estimated to equal 4%-5% of GDP by Morgan Stanley) suggests that there is no imminent danger of high inflation during 2011.
The inflationary outlook might be very different a year or two down the road. Energy commodities rose by 7.5% in December 2010 alone and across the globe, investors are preparing for a long-lasting commodity rally. These commodity price hikes are likely to affect producer prices and consumer inflation within a couple of years. Although a fully-fledged recovery of the housing market is not foreseeable, it is still highly likely that prices for shelter will increase at a much higher rate in 2013 than the 0.4% increase observed during 2010. What if we add to this upside inflation risk a marked real appreciation of the renminbi, for example taking place during mid 2012?
Given that inflation is still low, but surely on the rise, isn’t now the optimal time for the renminbi to appreciate? A swift appreciation of China's currency on the order of magnitude of 5%-10% followed by a return to the current slow appreciation policy might just be what is needed to contain inflation on both sides of the Pacific. Such a policy would increase short-term inflationary pressure in the US, but not beyond acceptable levels. Since this policy would ease inflationary pressure at home, without disrupting the Chinese export sector, the Chinese government, as well, should be more willing than ever to support such a revaluation.
Author's note: The views expressed in this column are those of the author and do not necessarily reflect those of the Swiss National Bank.
A shorter version of this column was published on 3 February 2011 on the Free Exchange Blog.
References
Auer, RA (2011), “Exchange Rate Pass-Through, Domestic Competition and Inflation: Evidence from the 2005/08 Revaluation of the Renminbi”, Working Paper 68, Globalisation of Monetary Policy Institute, Federal Reserve Bank of Dallas.
Auer, RA and AM Fischer (2008), “The impact of low-income economies on US inflation”, VoxEU.org, 13 June.
Auer, RA (2010a), "The effect of low-wage import competition on US inflationary pressure", Journal of Monetary Economics, 57(4):491-503.
Auer, RA (2010b), “Globalisation and Inflation in Europe”, VoxEU.org, 13 June.
Auer, RA, K Degen, and AM Fischer (2010), “Globalisation and inflation in Europe", CEPR Discussion Paper 6451.
Cavallo, Domingo and Fernando Díaz (2011), “China’s dilemma:Higher inflation or deflation of exportables”, VoxEU.org, 17 February.
Reade, J James and Ulrich Volz (2011), “Chinese inflation, monetary policy and the dollar peg”, VoxEU.org, 17 February.
China has raised benchmark interest rates for the third time since October, as Beijing intensifies its battle against stubbornly high inflation.
The benchmark one-year lending rate would rise to 6.06 per cent from 5.81 per cent, effective from Wednesday, the People’s Bank of China said on its website on Tuesday. The one-year deposit rate will rise to 3 per cent from 2.75 per cent but longer term deposit rates will rise by as much as 45 basis points.
“The goal is to encourage savers to keep their money in bank deposits rather than shifting to equities or property,” said Mark Williams of Capital Economics.
The timing of the increase, which came on the final day of the week-long Chinese new year holiday, appeared to be aimed at avoiding unsettling global and domestic markets. The previous increase came on Christmas day.
“Clearly, Chinese policymakers are increasingly focused on fighting inflation and asset price bubbles,” said Dariusz Kowalczyk, economist at Crédit Agricole. The fact that deposit rates were raised by more than lending rates “shows the determination to bring the real savings rate closer to positive territory”, he said.
The rate rise comes as China seeks to curb rising inflation, particularly in food prices, following a huge expansion in the money supply in the wake of the financial crisis. Goldman Sachs forecasts that year-on-year consumer price inflation in China is likely to have risen to 5.3 per cent in January from 4.6 per cent in December.
In addition to interest rate rises, Beijing has sought to tighten liquidity in the economy by raising the amount of deposits that China’s biggest lenders must hold on reserve with the central bank.
“For China, the year of rabbit is the year of inflation,” said Qu Hongbin, greater China chief economist at HSBC. “Given that growth is still strong, Beijing can now fight against inflation single-mindedly”. Most economists expect a further interest rate rise and a further increase in bank reserve ratios in coming months.
Last month, the PBoC increased the reserve requirement ratio for China’s biggest banks by 0.5 percentage points to 19.5 per cent, its highest level since reserve requirements were introduced in the mid-1980s and the eighth such move since the start of 2010.
Jing Ulrich, head of China equities for JPMorgan, said she expected inflation to remain high in spite of the move. “We expect that inflation will remain elevated in the next several months due to a number of factors, including rising food prices, as well as inflation passed through from increasing wages, commodities prices, and possibly energy costs if they are liberalised.”