Does Chinese inflation now constrain the Fed?

Tim Duy, with rather impressive timing, says yes. Rising inflation in China and the Gulf, the key regions in today’s "dollar zone," now have a large enough impact on prices in the US to limit the Fed’s ability to cut rates further. Rather than setting monetary policy for the US, Duy -- who had an office next to mine at the US Treasury back when we were both very junior new hires ten years ago -- claims the Fed has to set policy for the entire dollar zone. Duy writes:

Years of academic research led Bernanke to conclude that the Fed’s best response to the financial crisis is that which should have been deployed during the Great Depression. Fine on paper, but in practice he is using 1930’s monetary policy in the economy of 2008. And that 70+ year gap is exceedingly important in many respects, but perhaps none is more important than the current status of the US Dollar as a reserve currency, a status that allows the US to run a gaping current account deficit. The concern is that the Fed treats the external sector with something of a benign neglect when setting policy, effectively ignoring the reserve currency function of the Dollar. Hence, in a bow to Wall Street, policymakers unwittingly created an overly stimulative environment that feeds back to the US in the form of higher inflation.

This simply implies that the Fed does not sufficiently consider the reaction functions of other central banks when setting policy. Should they? In a world with limited capital flows, no. But in today’s globalized financial environment, the answer is increasingly yes. In effect, by encouraging open capital flows, the US has ceded some amount of domestic policy control.

It is an intriguing argument.

Once upon a time, Nouriel Roubini and I postulated that central banks would be unwilling to add ever increasing sums of depreciating dollars to their portfolios, and that the need to attract international capital to finance the (large) US external deficit could become a constraint on US macroeconomic policy autonomy. In such a scenario, US long-term rates would rise -- and the Fed might need to raise short-term rates -- even during a US slowdown. Rather than being able to adopt counter-cyclical policies designed to support domestic economic activity during a slowdown, the US might be forced to adopt pro-cyclical policies designed to assure access to sufficient external financing.

This scenario hasn’t materialized. US fiscal policy is now expansionary and the fiscal deficit is rising rapidly. US monetary policy is also expansionary. US policy rates are low, especially in real terms. Long-term rates are low too -- though no longer quite as low as they once were. All this has been possible, in some sense, because of an absolutely extraordinary increase in central bank reserve growth (supplemented by big flows into sovereign funds). My analysis suggests central banks and sovereign funds are on track to add over $1.5 trillion dollars to their portfolios this year (after adjusting for valuation gains). The huge rise in custodial holdings at the New York Fed strongly suggests that central banks remain the key sources of financing for the US.

Duy argues that the unwillingness of key central banks of move off the dollar -- and their corresponding willingness to finance the US at a considerable cost to themselves and their own economies -- nonetheless could constrain Fed policy.

His scenario is in a sense 180 degrees opposite of the scenario that Dr. Roubini and I laid out in 2004. But it ends up in the same place: the US looses a bit of monetary policy autonomy.

I would frame Duy’s argument as follows:

Key central banks remain committed to dollar pegs, and thus to adding to their reserves at a staggering pace and to lowering interest rates to US levels even in the face of strong internal inflationary pressures. Capital controls allow some countries a bit of additional freedom, but -- as China shows -- only a bit.

The pace of reserve growth has outpaced the capacity of central banks to sterilize rapid reserve growth, so rapid reserve growth is leading to rapid money growth. Combine that with low policy rates, and the result is rapid inflation throughout the dollar zone. See the Economist two weeks ago.

Inflation in the emerging world is bleeding over into inflation into the US. And thus the rest of the world’s determination to finance the US is contributing to US inflation, not just inflation in the emerging world.

This framing is pretty close to Macroman’s framing, but his is in verse.

There is little doubt that too loose a policy for the dollar zone would tend to push up inflation outside the US, and higher inflation outside the US in a more globalized world might feedback into US inflation. The question is whether the feedback channel from inflation in the dollar zone back to the US is strong enough to be a real constraint on US monetary policy.

The Wall Street Journal certainly thinks the feedback from a weak dollar is strong enough that it should be a constraint on the Fed. But that isn’t quite Duy’s argument. His argument is that the US is importing inflation from countries that are not allowing their currencies to appreciate against the dollar, not that the US the is importing inflation from countries that are allowing their currencies to appreciate -- and thus allowing the dollar to depreciate. The dollar hasn’t fallen relative to the Saudi riyal, or by all that much v the Chinese yuan.

There are two actually potential channels through which inflationary pressures in the emerging world -- or really very loose monetary policy in the emerging world and in the dollar zone in particular -- could feed back to the US.

The first is rising domestic inflation in a key exporter of manufactured goods -- namely China - could push up the price of the goods the US imports from China, and the rising price of imported goods in turn would exert broad upward pressure on prices in the US.

The second is that loose US monetary policy would push down real rates in the dollar zone -- and in the process help add to a resource intensive investment boom that pushes up the price of a host of commodities. Rising commodity prices in turn would contribute to rising price pressures in the US. The fact that both the Gulf and China hold gas prices down only strengthens this possibility.

I am a little bit skeptical about the first argument.

Imports from China are closer to 2% of US GDP than 3% of US GDP. Even if the price of Chinese imports rises by 5%, that wouldn’t have all that much impact on the broad price level. I don’t want to push this argument too far, as its logic suggests that trade with China is too small to have much of an impact on any key variable in the US -- and that isn’t something I believe. Rising prices on goods from China makes it easier for producers in other Asian economies -- and producers in the US -- to raise their prices. China’s impact extends beyond its direct impact.

But I also don’t see why rising prices in China necessarily needs through into rising prices in the US. Chinese firms could accept lower profits in order to keep up their market share. US firms that source production in China could too. Not all the gains from cheap Chinese production -- and rising Chinese productivity growth -- have been passed on to consumers. A lot seem to have been captured by firms.

Finally, I suspect that China’s impact on prices in the US has been rather more ambiguous than is often argued. I don’t doubt that the "China price" has kept prices of a host of manufactured goods down. But Dani Rodrik has persuasively argued that trade should raise the price of exports even as it lowers the price of imports -- not change the overall price level. The US doesn’t export a lot of goods or services to China, so that channel seems weak. But the US does export a lot of debt to China. And specifically a lot of housing debt with an Agency guarantee. Easier financing tends to push prices up. I consequently would attribute some of the pre-bust rise in housing prices to trade with China, and specifically the fact that China opted to buy financial assets rather than goods with the dollars it earns selling goods to the US and Europe. Now, to a degree, falling housing prices should help offset some of effect of rising prices for traded goods.

The argument that expansionary Fed policy -- magnified by dollar pegs that have led the central banks of economies with far stronger growth to follow the Fed -- has contributed to higher commodity prices strikes me as more plausible. Jeff Frankel has argued that low interest rates encourage commodity speculation by reducing the cost of holding a non-interest paying asset. Tim implicitly adds another channel: negative real interest rates in the dollar zone (combined with policies that have kept the price of a host of commodities below global market levels in much of the dollar zone) have contributed to a surge in commodity demand globally, and thus to a surge in the price of imported commodities.

Throw in the fact that oil and gas are inputs into the production (and transport) of a host of other goods, and I find it easier to see how a big rise in petroleum prices adds to pressure on a broad set of prices than to see how a rise in the price of assembled goods contributes to broad price increases.

And with oil at $125, US imports of petroleum will far exceed US imports of Chinese goods. See Professor Hamilton’s chart -- and remember that close to 3/4s of US petroleum consumption now comes from imports.

Tim Duy’s argument needs to be to be considered carefully, even if I am not yet sure I fully believe it.

Up until now, the central banks’ willingness to finance the US no matter what policies the US has adopted has increased the United States macroeconomic policy autonomy in a lot of ways. It allowed the US to cut rates and implement a fiscal stimulus despite a large external deficit, for example. The one way US policy has been constrained is self-evident: so long as China won’t allow its currency to appreciate (or appreciate by much), the US dollar cannot depreciate against key surplus countries. That historically has been key complaint of the reserve currency: countries with big surpluses don’t contribute enough to global adjustment.

Duy though suggests central banks’ willingness to finance the US -- indeed, their willingness to finance the US even if this adds to inflationary pressures in their own economies -- could also create constraints on US macroeconomic policy. In this case, though, the constraint may come from an excessive willingness on the part of other countries to finance the US. Dollar pegs (or in China’s case, heavy exchange rate management) potentially have led China, the Gulf and a host of emerging economies to import such loose monetary policy from the US that the global economy risks overheating even as the US economy slows. And in the process, they may have added to inflation in the US ....

At least that is the argument.

Talk about strange bank shots.