The Yuan and the U.S. inflation

Holding truths to be self-evident may work in political documents, but it will do nothing for you as a trader or market analyst. How many notions are more readily accepted than a weakening currency places upward pressure on inflation?

The logic, as is so often the case in these situations, is impeccable. An exporter to the U.S. gets paid in dollars and must either convert these dollars into his own currency or buy dollar-denominated assets with them. If the dollar is declining in exchange value, the theory goes, the exporter is going to want more of them in exchange for goods and services. The higher prices charged provide a higher ceiling for a domestic producer in competition with the exporter, and the result is a higher overall price level.

This neat little explanation actually subsumes a large number of assumptions, the most important of which is the exporter’s willingness to sacrifice profit margin in return for market share. The temptation to do so is at the core of most unfair trade practice claims; many domestic competitors believe exporters are willing to buy market share by selling at a low price.

Indeed there often is some truth in these complaints even though more often than not the complainant really is seeking protection more from his own bad business practices than from predatory exporters.

Another huge assumption is inflation is something other than a monetary phenomenon and reflects higher prices for selected goods. In the absence of monetary accommodation, higher prices for imported goods will divert purchasing power away from domestic goods with no change in the overall price level. The opposite is true, too: To the extent official monetary lassitude can expand the money supply, the overall price level can expand regardless. As discussed last month in “Japanese inflation and the yen” (Currency Trader, November 2007), creating inflation can be tricky when the banking system becomes dysfunctional.

Other assumptions include price elasticity of demand as well as substitution. If the prices of imports rise, we should expect to see both a decline in demand and a substitution effect to the extent both are technologically possible. One of the great frustrations in the political economy of energy markets is the limited extent to which both of these forces operate.

Americans feel quite literally trapped over a barrel. Finally, exporters get to respond in this game as well. They can hedge the risk of a weaker dollar, source materials in components in lower-cost regions of the global marketplace, improve their own production efficiencies and, yes, accept a lower profit margin to maintain or expand market share.

Overall, the apparently logical connection between a weaker currency and higher inflation is anything but a strong one in practice. Let’s turn now to the topic of how the heavily managed revaluation of the Chinese yuan (CNY) against the dollar has affected expected and reported inflation in the U.S.