U.S. Inflation Risk and
China's Currency Policy
The latest readings on
U.S. inflation show very subdued price pressures with much of
the recent decline (May) coming from a drop in the energy price
index with gasoline prices off noticeably.
Although U.S. inflation
has slowed this year, contributing to 2010's decline in U.S.
Treasury yields, the medium-term is filled with potential
inflation risks that could contribute to higher U.S. interest
rates. With U.S. unemployment currently high combined with
only modest private sector credit creation and economic growth,
the most likely catalysts for near/medium-term inflation
pressures would be global in nature - a rise in commodity prices
or a shift higher in U.S. import prices are considerations.
June 22, 2010:
The broad-based CRB commodity price index fell to its lowest
level of 2010 on May 25th and has since risen about 6%.
The impact of Europe's fiscal crisis was dominant last month as
asset prices in most of the riskier asset classes fell amid
extensive investor risk aversion.
A near-term rebound in commodity prices, including oil's 20%
climb since May 20th's 2010 intraday low, could have a
relatively near-term impact on monthly U.S. inflation measures
if the recent upward price momentum continues - this can happen
even absent a meaningfully positive economic growth scenario.
China ends its U.S. dollar currency peg - gradual
appreciation of the yuan is likely: Also under
consideration is the impact that global currency dynamics could
eventually have on U.S. import prices. On June 19, China's
central bank pledged to make its yuan (currency) more flexible
after months of pressure from the U.S. Treasury and Congress to
allow the yuan to strengthen. The currency was pegged against
the U.S. dollar at 6.83 since July 2008.
From all indications, the People's Bank of China is initially
poised to allow the yuan to rise only gradually against the U.S.
dollar, waiting for a less fragile global economic environment
before allowing for meaningful appreciation. A gradual
rise in the yuan against the U.S. dollar, subjects U.S.
importers to only minor currency related risks over the
very near-term. In the event the yuan's appreciation is
slow, pressures from Congress seeking a meaningfully stronger
yuan are likely to continue. This matter will likely
receive increasing attention in the coming months.
Impact of a stronger Chinese currency: A
stronger and more flexible yuan would help make China's approach
to monetary policy more independent while eventually, it would
lead to higher priced Chinese exports which would theoretically
enable U.S. goods to become more competitive. In addition,
a weaker dollar/stronger yuan should enable the U.S. to export
more goods to China, an outcome many in Congress discuss.
Since China continues to experience inflation pressures due
to incredibly strong growth, a stronger Chinese currency could
potentially slow the country's economy in the event demand for
China's exports slowed amid higher prices. China's yoy CPI
climbed 3.1% in May compared to a 2.0% yoy outcome for the U.S.
So far, higher reserve requirement for China's banking system
have not had a meaningful impact on slowing the country's near
10% (annual) growth. Although higher interest rates in
China can be justified, combining them with a stronger currency
could be more impactful on slowing the country's rapid growth.
Inflation from China: In reflecting back over
the past 20 years, China's high volume, low cost of production
was responsible for exporting deflationary pressures to much of
the world until the mid-2000's. As China's economy
expanded and more wealth was created, its cost structure has
slowly shifted upward and pressures to raise low-income wages
have accelerated.
As wages in China climb, cost pressures have accelerated and
combined with intermittent periods of higher commodity prices,
manufacturers face reduced profit margins, which ultimately mean
higher final prices or face risking the business. In
recent weeks, we've seen several manufacturers raising wages
significantly as labor markets have tightened while many local
governments have lifted minimum wage requirements.
Summary: Ultimately, a scenario of higher final
prices from China combined with a stronger Chinese yuan point to
increased goods prices for U.S. importers, which would mean
higher prices for U.S. consumers. In the event the Chinese
allow their currency to strengthen in a meaningful way in the
months and quarters ahead, it will redefine some of the
inflation risks facing the U.S. Taking this a step
further, in the event commodity prices rise in the coming
months, higher inflation considerations become a greater risk
for the U.S. interest rate environment.
Robert Podorefsky, Interest Rate Strategist (617) 973 - 4091
