Monday, January 10, 2011

Chinese Inflation and US Monetary Policy

Readers Question: Why does Printing money in the US cause inflation in China?

After reaching an inflation rate of 4.5% in November 2010, there are concerns China could face inflation in double figures by end of 2011.

The US is pursuing Quantitative easing because the economy is facing a big output gap. Unemployment is at 10%, and output is well below potential. US inflation is very low, and there are still fears of deflation. Therefore increasing money supply is unlikely to cause any inflation in US (at least in short term). However, the consequence of printing money in US has been
  • Fall in the value of the dollar. (increased supply of dollars tends to devalue the currency)
  • A weaker dollar has encouraged people to buy assets and commodities instead of the traditional US Treasuries.
  • This greater demand for alternatives to dollar assets has contributed to a boom in commodity prices (e.g. gold and metal). For a net importer like China, this rise in commodity prices has pushed up imported inflation.
  • Increase in liquidity. By buying US treasuries, the Federal Reserve is contributing to a rise in global liquidity. Foreign banks have sold US treasuries so they have more liquidity for lending to firms. This helps to increase demand in Asian economies.
Therefore, the decisions in the US have contributed towards inflationary pressure in other parts of the world such as China.

However, it is a mistake to see a direct link between US monetary policy and Chinese inflation.
  • If US prints money, the dollar should weaken and the Chinese currency appreciate. A stronger Chinese currency should help reduce inflationary pressure. However, the Chinese have made a specific decision to keep the Chinese currency undervalued and therefore allow expansionary growth.
  • The Chinese economy is growing strongly, there are many factors causing high growth apart from US monetary policy. This includes relatively low real interest rates for stage in economic cycle
  • If Chinese inflation is a problem, the Chinese Central Bank could raise interest rates.
Rise in commodities prices, such as food are due to many factors other than US monetary policy.

A lot is made of the US decision to pursue quantitative easing. But, if there economy is stagnant they do the right thing. Rather than spend their time complaining about US pursuing their best monetary policy, China should concentrate on rebalancing their own economy. i.e. allow currency to appreciate and try and stimulate more domestic spending rather than rely on oversees.


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