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Does Chinese inflation now constrain the Fed?

by Brad Setser
June 6, 2008

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.


  • Posted by JKH

    The following paragraph from Bernanke’s Tuesday speech (to which the market predictably overreacted) is nevertheless a reminder that the Fed doesn’t consider itself completely oblivious to an awareness of such risks:

    “In collaboration with our colleagues at the Treasury, we continue to carefully monitor developments in foreign exchange markets. The challenges that our economy has faced over the past year or so have generated some downward pressures on the foreign exchange value of the dollar, which have contributed to the unwelcome rise in import prices and consumer price inflation. We are attentive to the implications of changes in the value of the dollar for inflation and inflation expectations and will continue to formulate policy to guard against risks to both parts of our dual mandate, including the risk of an erosion in longer-term inflation expectations. Over time, the Federal Reserve’s commitment to both price stability and maximum sustainable employment and the underlying strengths of the U.S. economy–including flexible markets and robust innovation and productivity–will be key factors ensuring that the dollar remains a strong and stable currency.”

  • Posted by David Pearson

    The implication is that an accommodative Fed policy reinforces itself: low-to-negative real rates lead to China reserve accumulation lead to lower real rates. The same is true in the other direction. So monetary policy is “amplified”, as the Fed has recently discovered. Fed dogma hold the opposite view — that declining “rigidities” in the economy have made inflation less responsive to either policy or endogenous shocks. Perhaps, with the benefit of hindsight, this will be viewed as the Fed’s (and, in particular, Mishkin’s) biggest miscalculation.

  • Posted by Steve Austin

    I think that certainly Asian economies are next to adjust to the dollar and the driving factor should be inflation within their own economies. We have seen Canada and Europe adjust by ($1.60 CAN to $1.00 CAN) and the Euro by similar amounts. It seems logical to me that the next step is for Asian economies to adjust as they ultimately submit to the only effective way for them to fight inflation – let their currencies appreciate further.

    As far as the Fed being concerned and setting policy with concern about inflation feedback, I personally feel that this is close to last on their list of concerns. What is occurring here behind the scenes is not unlike the Tech bubble burst. You have a gigantic market of over the counter and trading derivatives with a significant percentage of them imploding. However, the window is extraordinarily opaque since visibility to outsiders is virtually non-existent.

    We’ve already seen the obvious housing related securitizations blowing up – however, I am still perplexed as to why there is not more talk about the $2 trillion (conservatively) or so other products which face sharp devaluations. Most importantly, over the counter credit derivatives, not to mention CMBS and a whole host of other smaller products (credit card securitizations, etc…)

    The Fed, in my opinion, is much more focused on the resulting deflation in the financial sector and the deterioration in bank balance sheets. I believe Bernanke sees this deflationary threat (justifiably) far more urgent than inflation. The cause of all this trouble? Lack of regulation in these derivatives markets, ultra lax bank lending, abandonment of Glass-Seagal, interest rates too low for far too long, investment banking lack of oversight.

    Inflation, it seems to me, constantly cycles through asset classes. It was not an issue when this monetary inflation remained in bonds (80s,90s,00s), stocks (90s), housing (00s) but as always it must feed back into commodities. The rub is that this time it is also coinciding with massive demand from Asian economies who have made adjustments in their economic systems and are returning to the norm of history. (For 18 centuries India and China were the largest economies – for two hundred years they missed out on industrialization). As this is a cyclical time for commodities anyways (underinvestment for 25 years in the sector therefore short supplies) I expect that commodities prices have far further to rise over the next decade.

    Will the Fed be concerned about the inflation feedback? Yes, but I believe it is hoping that policy makers in Asia and the Gulf are constrained by that inflation and will re-adjust their currencies. I don’t believe this is a Fed that will be all that concerned because they see what untenable position the last 25 years has put them in. They have no choice but to support financial system at this juncture because the threats are so much greater than most see.

    This is why we see them taking radical steps unprecedented in central banking history. Eroding half of their balance sheet by swapping treasuries for junk. Auction facilities for large amounts which are continually rolled over. I do not believe that the monetary base will actually grow unless the Fed’s balance sheet deteriorates completely, but raising interest rates in order to combat inflation from emerging economies would have a large negative impact on the ‘asset’ class which it is trying prevent from collapsing upon itself – over the counter derivatives. Counter parties must continue to be bailed out for the same reason.

    Sorry for the long post.

  • Posted by glory

    i think this was the key ‘graph:

    “Funny thing is it appears if we want to pursue Krugman’s policy of real wage acceleration, we will have to push up wages to compensate for the recent acceleration in wages, which sounds an awful lot like embedding higher inflation expectations into wage expectations. I imagine it would be something of a delicate task to shift compensation power to labor while convincing firms not to respond to that shift by hiking prices. The risk is that guaranteeing against a 1970’s repeat requires accepting a lower standard of living for the many Americans who have already seen virtually no gains since 2000, and this will become increasingly politically unpalatable in the months ahead. I am at a loss to see the expenditure switching policies that smoothly redistribute income (profits to wages) with out boosting aggregate demand in an environment that is already potentially inflationary.”

    ULC are ~70% of unit costs; ULC y/y are running below headline (if not core) which allows the fed to argue against a wage-price spiral (at least in the US).

  • Posted by bsetser

    Real wages could rise if profits fell, without much inflation — at least in principle. Remember, profits rose strongly v GDP over the past few years. Precisely how this will happen with lots of slack in the labor market, I don’t know.

  • Posted by Dave Chiang

    Under Congressional testimony, Bernanke was asked if the $2 trillion China PBoC holdings of US Dollars represented a problem. Bernanke stated response was that the China PBoC was stuck with depreciating US Dollars that can never be redeemed for anything close to their original monetary value. For Bernanke’s condescending remarks about the Chinese, if I were the Central Bank governor of China, I would unload at least some of those dollars for some other asset class. Unfortunately Bernanke is probably correct, the China PBoC is the big loser under US Dollar hegemony with the dollar the primary currency for global trade. For the trillions in real wealth exports of consumer products to the US, the Chinese receive fiat US Dollars printed in unlimited quantity by the Federal Reserve. “We have the modern technology of the printing press”, frequently states Ben Bernanke. The Neo-liberal global monetary regime established by the Washington Consensus Elites at the CFR exploits the peripheral developing nations exclusively for the narrow economic interest of the politically connected US capital. The US has systematically excluded the Chinese and Asian developing nations from having anything but a symbolic vote at the World Bank, IMF, etc. The US essentially controls the global financial system and the governing bodies. The economic imbalances that arise are a premeditated agenda by the Washington Consensus Elites to privatize the profits and socialize the losses to society as illustrated by the recent illegal Federal Reserve bailout of Bear Stearns at taxpayer expense.

  • Posted by Twofish

    I don’t see how Duy’s argument works politically. The Fed is appointed and accountable to politicians who are elected and accountable to voters who want jobs. The Fed can and does ignore what other Central Banks do because ultimately, the Fed is run by and accountable to people who care about the economic conditions of the United States.

  • Posted by Steve Austin

    Twofish – I agree. I think the only condition where we might see the Fed increase rates is based on our own domestic situation.

    If we see public sector unions strike and we see many commodities in contango then they will be forced to increase rates in order to prevent a wage price spiral and contain inflation expectations. The funny thing is that on a net basis I think their policy could still remain inflationary overall if they keep doing some of innovative things they have been doing recently.

  • Posted by Howard Richman

    I think you are correct in that the WSJ’s argument about the transfer of wealth is flawed.

    I also see two additional huge fallacies in their argument: (1) that the mercantilist countries are helpless victims of US monetary policy, and (2) that the fall in the dollar is caused by the Federal Reserve not holding up US interest rates high enough.

    *The Mercantilist Countries Are Responsible*

    The Federal Reserve is not responsible for the inflation in the mercantilist countries. The mercantilist countries are responsible for that inflation. That inflation is occurring because their central banks are increasing money supply much faster than their economies are growing. For example, the Chinese inflation is likely being caused by the Chinese government printing yuan in order to use them to buy dollars so that they can keep their currency from rising against the dollar.

    But the mercantilist countries have an alternative. THEY COULD LET THEIR PEOPLE IMPORT MORE AMERICAN GOODS! The Chinese government could let their currency rise to the level it should be. They could eliminate their 30% tariff on Michigan-made auto parts and their 30% tariff on US-made vehicles (including Pennsylvania-made Harley Davidson Motorcycles. They could eliminate their just-imposed tariff on Wisconsin-made Bucyrus heavy mining equipment.

    *The Real Cause of the Falling Dollar is Our Trade Deficits*

    It is true that when the Federal Reserve borrows more dollars to raise the US short-term interest rate, it causes private foreigners to lend us more money, which can help the dollar rise in value. However, such borrowing is at best a short-run fix. It is like solving your debt problem by taking out a new loan. The Wall Street Journal is ignoring a very basic economic fact. In the long run, when you import more than you export, your currency goes down in value. The way to strengthen the dollar is to reduce the trade deficits!

    The Federal Reserve is not responsible for the falling dollar. The foolish policies advocated by the Wall Street Journal and followed by US administrations since 1984 which have caused the US trade deficits to climb, and climb, and climb, are responsible.

    Howard Richman

  • Posted by Beau Butts

    Duy’s argument makes sense but would Asian currency appreciation not be inflationary for the U.S. as it increases the purchasing power of their domestic currency and allows them to import more? It would seems that would create such a large sclae increasde int he price of oil and other commodities that the overheating problem’s effects on the U.S. (as opposed to Asia whose inflation would be helped by appreciation) would be swamped.

  • Posted by aim

    Sester – “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.”

    Isn’t China’s ability to subsidize gas prices in China (and drive demand) related to their vast dollar reserves? Doesn’t the value of the dollar weaken as they spend to buy oil?

  • Posted by sk

    I’ve contended for a while and taken into account when tradin, that, with the Gulf and China shadowing the US$ the Fed DOES set monetary policy for the entire US$ Zone so to speak – not ought to, nor “is constrained by” but just an “isness” to it. Oil prices is clearly one example – another is wages – the Fed touts that wage inflation isn’t occurring – it may not in the US but it sure as hell has in China and the Gulf and with global wage arbitrage it STILL affects prices.

    They’ve been utterly foolish in their policy – whether by design or accident – the net effects are all around us at this moment. Idiots.


  • Posted by s

    Interesting that China is out this morning with official saying a stronger dollar is in its best interest that is the USA’s best interest. Not so much actually. China is clearly worried about the Treasuries and the destroy the dollar in drag policy. Furthermore, Trichet is essentially spitting in Bernanke’s face. Let’s hope it is nod a fade and he actually stays with it. Bernanke will follow in the footsteps of Greenspan figuratively (and literally of course). In a few years time when we are still dragging along the bottom, all the hero chants for saving Bear Stearns will be sneered, just like the cult worship of Greenspan turned to jeers. The conundrum for the government is that a reversion to a normal yield curve would kill the US economy and further bankrupt the US gov (and banks) – if that is possible? Rate hikes? Laugher…Tips Spreads? Laugher!

    Agree fully that India and China will essentially spend on infrastructure into oblivion to keep GDP growing and the window dressing fresh. Look at components of India growth and they are already doing it. China has basically said that it is going to do the same thing. Brazil is also investing. All are going to be raising rates, Brazil already has. Deathly combination for the United States – dollar tanking, commodities strong to stronger and Bernanke with his finger in his noise dreaming up auction facilities to further mummify the banks.

    The greatless generation strikes again.

  • Posted by glory

    commodities in contango backwardation 😛 fixed that for you!

  • Posted by Steve Austin

    glory – are you referring to my post?

  • Posted by glory

    yes stone cold 😛 check it!

  • Posted by Steve Austin

    heh, that’s Steve Austin as in The Six Million Dollar Man (tv show)- but that shows my age.

    I’m pretty sure I had that right. Contango indicates that long dated futures are higher than spot prices and/or that longer dated futures are higher than near dated futures. When this occurs it is an indication that consumers of that commodity expect prices in the future to rise. That is an indication of inflation expectations rising.

    We are not there yet, in general, in commodities. That is why so far this commodities bull movement over 7 years has been a demand story – that is typified by backwardation. Next it will be a demand and inflation story. All that long before it becomes a bubble – when all commodities are sharply in contango trading at multiples of spot prices. Check it 🙂

  • Posted by Realist

    I think I should re-post this comment on this thread too.

    I’m not applying for the post of CFR defendant, but I also think it’s fair to point out that Benn Steil, the Director of International Economics at the CFR has been consistently advocating, at least since his summer 2006 paper “Why Deficits Matter” coauthored with Menzie Chinn, for a US monetary policy that is the opposite of what Ben Bernanke has been doing especially since last September. He further stated that position lately in his Apr 23 paper “How the Rise of the Euro Threatens America’s Dominance”. So here there is a high-ranking CFR official sharply departing from “the Washington Consensus Elites”.

    But it is his latest piece, the May 20 Testimony on Financial Speculation in Commodity Markets Before the Senate, which is particularly insightful (also on the biofuels issue). I found the following paragraph just prescient:

    “Longer-term, governments themselves may actually fuel the upward commodities price trend by diversifying central bank reserves into commodities as a way to avoid precipitating further depreciation (vis-à-vis other currencies) of their existing huge stocks of dollar-denominated assets – in particular, US Treasurys.”

    Because the potential Saudi move I mentioned in comment #31 of previous post “Scary” is exactly that, with the commodity in question being their oil still in the ground.

  • Posted by don

    I wonder. The dollar’s drop against the euro increases import prices denominated in dollars, but allows euro-denominated prices to remain steady. A country that pegs its currency to the dollar will tend to import inflation, which will also feed back to U.S. import prices. So, I’m not sure how critical the ‘reserve currency’ role of the dollar is when looking at the effects of expansionary U.S. monetary policy on inflation. However, by helping maintain growth in China, the expansionary monetary policy pushes up global demand for food and oil, and these relative price increases are proving bothersome. Also, the pegs allow the peggers to steal some of the aggregate demand created by expansionary U.S. fiscal or monetary policy. If this causes Ben B. or Congress to create greater stimulus to achieve their U.S. aims, then it may result in greater global inflation.
    I too, was at Treasury 10 years ago. I must have seen you guys in the halls.

  • Posted by bsetser

    2fish — Duy’s argument is, I think, that monetary policy (and energy policy that supports oil demand via subsidies and thus keeps prices higher than otherwise) in China and other countries that peg to the $ now has a stronger enough effect on domestic US conditions that the fed can no longer ignore external conditions.

    Yes, a falling dollar would have a similar impact directionally on US import prices. But if the falling dollar produced more monetary autonomy in China and the Gufl and thus less inflation there, it might produce less inflation globally — and a globally less expansionary monetary policy might mean lower commodity prices.

    That is least is the hint. So in the Duy model, it in some sense is excessively expansionary monetary conditions outside the US that prompt the fed to tighten, as in some sense the Fed ends up caring more about inflation in China and the Gulf than policy makers in China and the Gulf …

  • Posted by bsetser

    Don — we were in what then called OASIA, in the IMI office led by Joe Gagnon. We were mostly over at 1440 NY avenue tho, so you might not have seen all that much of us in the hall … tho at various times I was also in main treasury (4th and 5th floors, pre-renovation)

  • Posted by Realist

    IMV the critical constraints on monetary policy will increasingly come from physical reality.

    The current US monetary policy was OK when the world was far from the physical limits to growth (or in other words, when the world oil production was on the way up to Hubbert’s Peak), and lack of aggregate demand was the factor that prevented economic output (and employment) from growing at their potential sustainable levels. This is no coincidence as Prof. Bernanke’s mindset seems to have been shaped by the study of the Great Depression.

    But now that the world economy is bumping against the physical “limits to growth” – most notably, but not exclusively, in oil production – that kind of monetary policy is not just ineffective to increase production (as monetary stimulus cannot reverse the decline of oil fields, it only raises the price of the critical limiting resource) but downright dangerous, in that by stimulating demand it increases the likelihood of fuel shortages, which may prove more disruptive to society than bank failures.

    Now, how could be a monetary policy be “safe” in this respect? E.g. by applying the following “safety overrides”. Defining “stocks” as inventories of crude oil, gasoline or distillates:
    – If any stock is in the lower decile of its average range, do not cut rates.
    – If any stock goes below its average range, raise rates.
    Sure enough, a matching “safe” fiscal policy should exempt inventories of crude oil and petroleum products from any tax.

    An analogous consideration can be made regarding construction and the status of the electrical grid. Construction is perhaps the activity most sensitive to credit conditions. But I wonder if people perceiving the decline in construction activity as bad have ascertained whether the capacity of the electrical grid can accommodate the incremental demand from the new homes they’d like to be built. Most probably the answer is no, and those advocating a monetary policy that encourages further home construction have no idea whether the ensuing electrical power demand has the potential of loading the electrical grid beyond its capacity. And the grid is either up or down. And if it’s down for a long time, societal order just collapses.

    Sure that collapse can be prevented by draconian measures. In such an emergency, the Government can take whole cities like Las Vegas off the grid and let them bake to save the rest of the country. Or they can send the police and National Guard home by home to seek and destroy air conditioners. Or they can set exponential pricing for electricity to force people to skimp on it.

    All options that make a credit crunch and recession not look so bad after all.

    An associated issue IMV is that the coming times will demand “heterodox” monetary policies, whereby the Fed will lend funds to banks in a two-tier system:
    – at a low rate only for specific funding of projects related to renewable energy sources (not corn ethanol!)
    – at a high rate for all other purposes.
    After all, a Central Bank lending to commercial banks in a multi-tier system is something that has been done in Thirld World (excuse me, emerging) countries for decades. And IMV encouraging construction of wind farms while at the same time discouraging suburban home construction is the safest way to avoiding societal collapse.

  • Posted by Realist

    BTW, my previous comment applies to any country’s monetary policy, not just the US.

  • Posted by glory

    you’re right that contango is when further-dated contracts are higher than spot or near, but they are not indicative of expectations of higher prices in the future; indeed backwardation is more often viewed as bullish, and contango bearish.


  • Posted by Twofish

    Realist: After all, a Central Bank lending to commercial banks in a multi-tier system is something that has been done in Third World (excuse me, emerging) countries for decades.

    And it generally works badly because people who can get money at low interests then proceed to lend it at high interest rates rather than actually spending it.

    This is one reason that Chinese SOE’s have large savings. They can make quite a bit of money by effectively lending it.

    I really don’t think we are anywhere near physical limits to growth. Once the cheap oil runs out, people will move to other things.

  • Posted by Twofish

    In mid-March, I don’t think that the Fed really was caring that much about inflation or the value of the dollar. The main thing on its mind was preventing the collapse of the world financial system. There were some moments in which people were staring into the abyss and it was truly frightening.

    Also, it’s not clear to me that the world is more financial interdependent in 2008 than in 1925.

  • Posted by Dave Chiang

    From Peter Schiff,

    Game Over for the US Economy and the Dollar

    Over the past two generations, the American government has launched many failed campaigns. To name just a few, there has been the war on drugs, the war on poverty, and the continued attempts to improve education. But the strong dollar policy must be seen as the poster child for all failed Federal policies. In an unprecedented move, the Fed Chairman is now adding his voice to the chorus and using the same rhetoric previously used by Treasury alone. That’s two people saying the words…not just one. A double barrel strong dollar policy!

    The real take away from Bernanke’s comment is not that the dollar is about to rally, but that it is now more likely to sink even lower. I believe the main reason Bernanke has refrained from mentioning the dollar in the past is that he did not want to be put in a position of actually having to do something about its decline. He is now so fearful of an imminent dollar collapse that he must have felt compelled to throw down the gauntlet despite his fear that someone might actually pick it up.

    My guess is that currency traders will ultimately see this as an act of desperation. When the dollar keeps falling a chorus will swell to demand that the Fed put teeth in its new policy. If Bernanke does nothing the world will finally see a naked emperor and the dollar’s decline will turn into a rout. If, on the other hand, the Fed raises rates to defend the dollar, and only a short term bounce results, then all remaining confidence in the Fed’s ability to support the dollar will evaporate as well. This is probably Bernanke’s greatest fear and is likely the main reason he waited so long before mentioning the dollar. The fact that he felt compelled to do so now likely means he knows the game is coming to an end. Got gold?

  • Posted by Anon1

    Oil near $140.

  • Posted by don

    I think Tim’s piece incorporates something that is missing in debates that talk about the ‘value of the dollar’ as if it were a single magnitude. The dollar is undervalued against European currencies and overvalued against Asian currencies. The solution to this problem comes under the purview of Tim’s and Brad’s (and my) old employer – the Treasury, not the Fed. The Treasury’s inaction is crimping the Fed’s options. The recent Administration push to reduce currency interventions in Asia is too little and too late.
    Boy, I hope your assessment is wrong, Dave C., but it has enough hint of truth to be scary.
    (Brad – I was on the fifth floor when the fire happened.)

  • Posted by Twofish

    I don’t see that much that Treasury can do really. Treasury doesn’t determine fiscal policy, Congress does, and ultimately Congress is beholden to voters.

    Also one reason I tend to be an optimist about the United States is that I heard a lot of the same things about the US falling apart in the late-1970’s (for many of the exact same reasons) and it didn’t happen.

    History doesn’t stop. Even if the alarmists are right and everything in the United States falls apart, time doesn’t end.

  • Posted by jin

    Nobody here is seriously worried about U.S., 2fish. Though I am worried about China due to the huge inflation pressure.

  • Posted by bsetser

    with oil at $140, slumping payrolls, a capital constrained financial system and a large and now likely once again growing external deficit, i am start to worry about the US. we will eventually right the ship, but it sure seems to be leaking in a lot of places.

  • Posted by don

    Twofish – Treasury is responsible for exchange rate policies. And it was empowered by Congress to determine when foreign currency manipulations should be addressed. But in response, it failed to brand China as a currency manipulator.
    In my view, the currency pegs cause the Fed to loosen more than it otherwise would. Without the pegs, the interest rate cuts would have a larger effect on the trade balance, reducing the leakage to the foreign sector by more than can happen when only the European currencies respond. So, with the pegs, monetary policy is less effective and bigger doses are needed.

  • Posted by aim

    Don, I agree with you completely.

    I too worry about the US because soon it will be unprofitable to run some businesses. Airlines are cutting back service. Some energy dependent small businesses operations, like fishing boats and independent truckers, can’t afford to operate. All sorts of businesses that depend on commodities will have to raise prices or stop operating. My electric bill could be going up 16% due to the rise in coal prices. Unless dollar rich nations stop subsidizing demand, it seems that prices will keep rising.

  • Posted by Twofish

    don: Treasury is responsible for exchange rate policies. And it was empowered by Congress to determine when foreign currency manipulations should be addressed. But in response, it failed to brand China as a currency manipulator.

    If you have a floating currency then your exchange rate is going to be determined by fiscal or monetary policy, neither of which Treasury has any control. Under Section 3004 of the Omnibus Trade and Competitiveness Act of 1988, the only thing that happens if Treasury calls China a “currency manipulator” is that they have to negotiate with China, which is what they are doing anyway. It’s really quite silly.

    Of course, one tried and true political role is that of the “designated scapegoat.” Everyone organization needs someone to blame for not doing something no one really wants done, and I think that this is the real purpose of Section 3004. So a Congressman can get on the campaign trail and scream at Treasury and look nice at committee meetings and say its Paulson’s fault that no one can do anything.

  • Posted by Twofish

    One basic principle of “getting things done” is that authority and responsible have to be matched. If you make someone responsible for doing something, then you have to give them authority to do it. If you what to give them authority, then you better make them responsible for the consequences.

    In the case of currency exchange rates, making Treasury responsible for it is silly if you want anything done, because they have zero authority to do anything that might actually change exchange rates.

    Now the Federal Reserve *does* have authority to set exchange rates. The curious thing is that it has no responsibility to do so. Under the Humphrey-Hawkins Act, the responsibility of the Federal Reserve is to maintain growth and minimize inflation. The interesting thing is that currency exchange rates isn’t mentioned, and even more interesting neither is balance of trade.

    Part of the reason this is the case, is that under Bretton-Woods the institution that maintained exchange rate stability and balance of trade was the IMF, but they have basically self-destructed and become completely irrelevant in global economics. The only real power that the IMF had after the collapse of Bretton-Woods was the power to grant or withhold funds in a currency crisis, but they used that power so badly in the 1990’s that everyone has created these huge reserves, at which point the IMF because completely powerless.

  • Posted by Twofish

    Global markets did constrain the Fed when it negotiated the Bear-Stearns deal in mid-March was Asian markets. Extremely bad things would have happened had the Tokyo and Hong Kong markets opened without a deal in place.

    Yes, Bernanke can be faulted for causing oil prices to hit $140 and 5% unemployment, but what people where looking at when the decisions were being made was far scarier.

  • Posted by RSA

    Follow the Money ($4.55bln)
    Weird weekend on FT after DJ down 400 points.

    What happened to building 7?

    Any one bother to comment on this ? Would this thing help to reduce oil price ?

  • Posted by Judy Yeo

    Apologies for a long comment, sorry!
    These are just some thoughts, not necessarily right or coherent


    Could the import of inflation through “assembled” goods be seen this way, these goods aren’t exactly luxury, not perishables, yet somehow the ordinary household cannot do without them. Obviously, price tolerance has a level but as long as price increases do not go beyond that level, they are tolerated, hence, inflation on a silent level. Of course, the Chinese manufacturers can absorb higher prices and accept smaller profit margins , but only to a certain tolerance level as well, beyond that, even they would have problems. The gallop of oil prices obviously tests that tolerance levelconstantly, be that part of the manufacturing process or transport. At some point, the price /cost increase gets passed on, that becomes part of the inflation matrix. Things are a bit more complicated when the manufacturers are actually controlled by American interests, ultimate profitability may be located on the sale to end consumer part as well as on cost savings on the manufacturing end. The value chain however does not stop “multiplying” the points at which price and cost inflation comes in. What is interesting is at what point do declining profits of American companies who manufacture in China and export those goods to China contribute to the stag part of stagflation?

    As for commodities your quote “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.”

    But it doesn’t sound quite right, no one buys iron /steel(for example) if they don’t need it, the suppression of real price levels of commodities might well make it less of a consideration when it came to purchases, but surely price does not produce demand. Even if the buyer is looking to profit from selling on the commodities, at least they are impacted by real delivery issues, for example,they have to consider storage costs. Arguably, the demand -price interaction you mentioned has more to do with speculators on futures contracts who generally do not actually make physical delivery nor take physical delivery.

    As for Chinese preference to invest in debt rather than imports of goods, could that be on a official basis? It may sound silly but whsat would the Chinese government do with a bunch of American imports, consumer goods need to be “consumed”, unless you can convince the Chinese government bthat they truly need to distribute a chevron per household in China (for example), it’s going to be tough asking the government to spend on goods. Besides the goods the government is interested in buying , the American government is probably less interested in selling, think technology etc. Wealth distribution hasn’t reached a point where Chinese locals can generally afford American goods, besides, I suspect most Chinese tend to look for point of origin/manufacturing on foreign label goods. I remember my landlord in China attributing part of the exorbitant rent to her having purchased foreign label goods for the house, didn’t want to embarrass her by pointing out that the electrical department at a nearby shopping mall had listed that big ticket product as being produced in a province of China. To be fair, it did cost about 6 months of an ordinary worker’s salary, that says something about consumption capability.

  • Posted by bsetser

    Judy — Negative real interest rates = more investment, and thus more demand for cement and steel and the like. And more demand for energy, as their production is energy intensive. Artificially low energy prices encourage its use — just as high prices discourage energy use. There is little doubt that combination of low rate ands lower than market prices has contributed to the surge in chinese (and gulf) demand for a host of commodities.

    At a market exchange rate, China might develop a taste for more us goods — or chinese producers might conclude that they are better off producing for the Chinese market. Or American producers might move downmarket and try to produce goods in the US to sell to the Chinese mass market. It sounds crazy, but if prices change incentives change and behavior changes — just because a country is poor doesn’t imply that it will run a trade surplus b/c it cannot afford imports. A host of countries in eastern europe run large trade deficits globally and with richer western europe.

  • Posted by aim

    2fish – Yes, Bernanke can be faulted for causing oil prices to hit $140 and 5% unemployment, but what people where looking at when the decisions were being made was far scarier.

    Currency manipulation can be faulted for these problems. The Fed was trying to stop the US economic decline caused by the competitive advantage that Asia nations got by currency de-valuation. Large builds in dollar reserves is a by-product of an effective currency de-valuation strategy by many nations. This is starving the US for liquidity. The Fed has to lower interest rates.

  • Posted by Steve Austin

    >>>glory said – you’re right that contango is when further-dated contracts are higher than spot or near, but they are not indicative of expectations of higher prices in the future; indeed backwardation is more often viewed as bullish, and contango bearish.>>>>

    “but they are not indicative of expectations of higher prices in the future” That is the very definition of contango. 800 years of pricing history tells me that. I’m not talking about a short term blip of a commodity going into contango and mitigating factors pulling it back into backwardation and back and forth.

    I’m talking about the fact that whenever you have a broad based movement upwards in food and fuel prices and if you ultimately have many of these key commodities moving sharply into contango then obviously the market is expecting sharply higher prices in the future. That is the definition of contango itself – the market sees higher prices in the future. This always coincides with inflation expectations. It is precisely the reason why when Bernanke was asked whether he sees staglfation in the Senate a few months ago, he could say ‘no, I don’t’ – because they was not a broad basket of commodities going into contango.

    We are not quite there yet.

    What O’Grady is doing in that link you posted is he is using an era of disinflation to draw a correlation to a present circumstance. It is precisely why so many investment advisors have completely missed the boat on calling this movement in commodity prices. They care only to look back 25 years. This happens to coincide with a secular bear market in commodities. Of course, just because a commodity moves briefly into contango does not mean that inflation expectations are broadly rising. I am talking about a circumstance when all major commodities are moving deeply into contango.

    Should we see all commodities move into contango it is and has always been a very clear indication (20th century alone – 1906-1923, 1933-1955, 1968-1982) and many times previous that inflation is expected in a big way. That is usually when public sector unions strike and that is when the central banks have little choice but to take action to prevent a wage price spiral.

    Like I say thus far this has been a demand story typified by backwardation. Next it will become a demand & inflation story – historically this occurs when food and fuel have been rising but the pivotal point has traditionally been when meat costs are passed through to consumers – which I expect within a year. Expect a rout in the bond market at some point.

  • Posted by JKH

    US import price inflation can result directly from floating exchange rates (e.g. Euro), or indirectly from fixed exchanges via foreign inflation (e.g. RMB). In the case of the RMB and other pegged currencies, pent up foreign inflation risk goes hand in hand with unsustainable fixed exchange rates. Tim Duy addresses the second type of import price risk.

    PBOC subsidizes Chinese export pricing with a pegged exchange rate. Chinese exporters can further “subsidize” their pricing by offsetting cost inflation with profit margin reductions.

    From the Fed’s perspective, there are two fundamental questions regarding import price risk:

    a) To what degree do import price increases translate to a more generalized US inflation?

    b) What is the appropriate US monetary policy response?

    With respect to the first question, the US economy is still relatively closed, there is limited pass through of either FX or foreign inflation risk in final import pricing, and there is some doubt as to whether actual imported price increases will contribute to a more general domestic inflation through wage increases. For example, oil price increases can affect a variety of derivative products, but if the increases aren’t monetized to offset purchasing power losses through higher wages, the result is product substitution and some offsetting deflationary tendency rather than generalized inflation.

    With respect to the second question, the Fed needs to consider the effect of import price increases, regardless of whether the source of pressure is via exchange rates or foreign inflation rates. A price increase is a price increase, regardless of its constituent sources. The Fed needs to be no less vigilant on the foreign exchange effect (e.g. Euro) than it is on the foreign inflation effect (e.g. RMB). But if the actual pass through of price increases doesn’t threaten a generalized inflation, in the Fed’s view, the monetary policy response will be restrained. Moreover, the Fed may have a view as to the sustainability of certain import price increases (e.g. energy and commodities). The Fed needs to calibrate the potential for import price diffusion before responding aggressively to selective price increases with monetary tightening.

    The Fed is well aware of the potential feedback of its own monetary policy setting in terms of foreign monetary policy in those countries that peg to the dollar, and the natural effect that may have on foreign inflation. And it is equally aware of the distorting effect that dollar pegs have for both the resolution of international surpluses and deficits – e.g. how the RMB peg puts disproportionate pressure on dollar/Euro adjustment, instead of sharing adjustment with dollar/RMB and Euro/RMB.

    Because the dollar is the prime reserve currency, the Fed has only monetary policy to respond to imported inflation effects that arise from both foreign exchange rate policy (e.g. floating Euro) and foreign monetary policy (e.g. tied RMB interest rates). The result is a world that is highly levered to US monetary policy through pegs. I guess this is Duy’s point, expressed in reverse. I think the Fed is well aware of this. And this leverage will operate on the way up as well as the way down, with potentially dire consequences. If, as, and when the Fed tightens, it will tighten all three of US domestic monetary policy, the US dollar exchange rate, and foreign monetary policy in those countries that peg to the dollar. This is quite a nexus of global adjustment at the beginning of a Fed tightening cycle. Start of cycle monetary tightening can produce violent market reactions in any event. It would be better if a global tightening cycle could include some preliminary peg adjustments (China, if not the Gulf) prior to Fed monetary policy changes, rather than putting the full burden of starting with US monetary policy alone. In addition to the deflationary effect of the housing and credit cycles, and the absurdly manic and extended state of energy and commodity markets, this fragile global hyper-sensitivity to US monetary policy is why the Fed will be ultra-circumspect in timing the start of the next tightening cycle.

    The US economy, while down and out, remains the most extraordinarily flexible system in the world, by a few light years. Given the damage done, the recapitalization process for US banking has been tremendously successful to date. It is short sighted for some to be lamenting losses on newly issued shares. That happens in bear markets. The fact that more capital issues remain to come is no impediment to the full adjustment that is required and the rejuvenation will eventually come about. And you can be sure that the foreign CBs and SWFs will have their cash reserve snouts well into the trough, once greed returns to the US stock market in force. Like any overly cautious investor with too much low yielding cash, they’ll be late by definition, but they won’t be able to resist.

  • Posted by Can Fed Prevent Inflation

    The Fed needs to realize that it kept interest rates too low following the 2001 recession, and this was the primary driver for the housing bubble. As soon as credit and housing markets stabilize, it needs to raise interest rates again.