Free exchange | Exchange rates

What the yuan means for American inflation

The rise of cheap Chinese imports has substantially contributed to the low inflation environment in US during the last 15 years. Now that prices in China are on the rise, this effect will be reversed

By Raphael Auer | Princeton University

Raphael A. Auer is the deputy head of the International Trade and Capital Flows Unit at the Swiss National Bank and a research associate at the Lichtenstein Institute of Princeton University.

AT FIRST thought, the recent rise of inflation in China seems to be reassuring news for American policymakers concerned with the trade deficit: price increases in China make US firms more competitive and high inflation may also induce China to let the yuan appreciate at an accelerated pace to lower the cost of imported goods. Considerations 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 (this recent post on Free Exchange frames the magnitude nicely).

If the American trade deficit is reduced via either Chinese inflation or a nominal appreciation of the yuan, 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*, 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 yuan appreciate by a combined 17% vis-à-vis the dollar. Matching this appreciation with sectoral US price data, it documents how a higher yuan 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 yuan causes American producer prices to increase by a little over half a percentage point.

The figure above uses these findings to simulate the effect of a yuan 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 American 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 yuan. 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 yuan appreciation. American 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 full 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 yuan, 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 yuan 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 Rim: 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.

* Raphael A. Auer, “Exchange Rate Pass-Through, Domestic Competition and Inflation: Evidence from the 2005/08 Revaluation of the Renminbi”, Working Paper No. 68, Globalization of Monetary Policy Institute, Federal Reserve Bank of Dallas, January 2011.

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