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CHINESE IMPORTS ARE MANY, BUT INFLATION ISN'T ONE

For years, globalization was touted as undisputed good news in terms of the low prices it delivered to consumers. It was unqualified bad news only if you happened to be the fellow who made the goods now being produced in China.

Now the tide has turned. After more than a decade of "exporting" deflation, China has gone over to the dark side, according to U.S. government statistics. The price of Chinese imports has risen in the past few months, triggering predictable reactions based on faulty assumptions.

Specifically, the question is, Can one country import inflation from another? In the case of China and the United States, it depends on whether one is flying from east to west or west to east.

China pegs its currency to the U.S. dollar. In other words, it has adopted U.S. monetary policy as its own. If the U.S. inflates, China inflates, not the other way around.

"If China had an independent monetary policy and its currency wasn't linked, rising prices would be offset by a falling currency and the U.S. wouldn't see any effect," says Jim Glassman, senior U.S. economist at JPMorgan Chase & Co.

The broader issue is whether a sovereign nation with an independent central bank can import inflation - or deflation - from overseas.

The answer is, it depends on what the monetary authority in the importing country does. A sovereign central bank isn't a "price taker," or an inflation accepter. Instead, it always has the ability to offset any relative price change, be it in domestic or foreign goods, with tighter monetary policy.

Forget about borders and exchange rates for a moment and think about individual prices in the domestic economy. Let's say the price of oil goes up because demand increases. Is that inflationary?

Former Federal Reserve Chairman Alan Greenspan used to explain to Congress that relative price changes are not inflationary, per se. That is as true for the price of oil as it is for the price of labor (wages), although you'd never know it from listening to policymakers.

For a given stock of money, a rise in the price of oil may translate into a one-time rise in the price level. With time, the price of something else will fall as consumers cut back on nonoil purchases.

The same is true for the price of imports. If consumers have to pay more for items made in China, they will have less money to spend on domestic goods and services and other foreign imports - unless the central bank accommodates those higher prices by allowing the money supply to increase.

So it is always and everywhere the province of the central bank to determine its domestic inflation rate.

Fed Gov. Don Kohn and San Francisco Fed President Janet Yellen have challenged the notion that central banks have to passively accept whatever price increases are thrust on them from abroad.

"In the end, however, policymakers here and abroad cannot lose sight of a fundamental truth: In a world of separate currencies that can fluctuate against each other over time, each country's central bank determines its inflation rate," Kohn said.

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