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.

“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.

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.

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.

Brad

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.

What happened to building 7?

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

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.

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.

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.