The world is still spinning and so are events; here’s a short summary of the interest rate maneuver by the Peoples Bank of China from Vox Research:
What does PBOC’s latest rate hike tell us?
Yiping Huang
20 October 2010
On 19 October, the People’s Bank of China announced a series of rate hikes. This column argues that the moves were aimed at combating domestic inflation and avoiding the mistakes of Japan in the 1980s.
This policy adjustment tells us several things:
- China’s monetary policymakers see greater inflation risks than the headline CPI inflation data;
- the government is probably trying to avoid the Japan mistake: loosening domestic monetary policy in order to reduce pressure for currency appreciation;
- therefore currency appreciation is likely to continue, if not accelerate; and
- the authorities might adopt certain measures to control the capital account temporarily in order to discourage “hot money” inflows.
China’s headline CPI rose to 3.5% year-on-year in August, up two-tenths of a percentage point from the previous month. A look at the disaggregated data reveals that inflation is mainly driven by food prices.
This is the reason why some officials argue that monetary tightening was neither needed nor effective. Nevertheless, during the thirty years’ reform period, almost every major inflation problem, that in 1988, 1993 and 2007, was initially caused by food inflation. Monetary policymakers have learnt not to treat food inflation lightly.
Inflation momentum
The current momentum of inflation is already pretty serious. CPI rose by 0.6% month-on-month in August, which can be translated into an annualised rate of 7.2%. This certainly is way above the central bank’s target. More importantly, the headline number is probably grossly underestimated due to under-represented service prices in the basket.
Some economists suggest CPI is currently closer to 5%-6%, compared with the official number of 3.5%. The Ministry of Commerce collects market prices for agricultural food every week. These numbers confirm that food prices already rose during the past three month at annualised rate of above 30%.
Huang describes wage increases of 20% and large increases – albeit at declining rates – of bank loans. China’s inflation is not the benign form that arises from the expansion of ordinary commerce. This is the monetary authority adding currency to the economy to cure a presumed ‘currency shortfall’ relative to the flows of overseas money into that country. China understates its inflation the same way the US government misstates everything. It has a ‘story’ of growth and history- superseding national success to sell to the gullible. China will continue to lie about its inflation until workers are being paid every day.
Keep in mind two things;
- One is ordinary inflation is the consequence of business expansion increasing credit and the money supply. Hyperinflation is the monetary authorities putting more and more currency into circulation.
- The other is you heard about inflation/hyperinflation in China here first.
Meanwhile the effects of interest rates on lending and F/X are overstated. John Hussman wrote an article which indicates the measuring tools the establishment uses to calculate ideal F/X:
Purchasing Power Parity (PPP):This describes the tendency for long-term exchange rate movements to reflect long-term changes in relative price levels between countries. Suppose for simplicity that a given basket of goods costs $10 in the U.S., and costs FC40 in some other country (where FC is simply a unit of foreign currency). If the goods are identical and can be transported costlessly without any barriers, one would expect that $10 = FC40, or that $1 = FC4. So the exchange rate would satisfy purchasing power parity if one dollar traded for 4 units of foreign currency.Suppose the foreign country is highly inflationary, so that the price of that basket of goods increases to FC60, while the U.S. experiences no corresponding inflation. PPP suggests that the exchange rate should track the relative price levels between the two countries, resulting in a new exchange rate of $1 = FC6. This would be a “strengthening” or “appreciation” in the dollar, since each dollar would command a greater amount of foreign currency. Conversely, this would be a “weakening” or “depreciation” in the foreign currency, since each unit of FC would command fewer dollars.
What PPP doesn’t do is illuminate the feedback loops between countries, why inflation in one country is due to deflation elsewhere. Deflation renders PPP unreliable as the supply/consumption relationship is skewed by changes in marginal returns. In deflation some prices increase even as money/credit collapses.
Peak oil renders oil more costly in real terms; return on that oil declines. Because there are fewer returns on crude use, nominal price of crude declines. This increases the relative value of currency exchanged for it … which is in turn a commodity to be exchanged alongside the crude oil. If oil cannot be had directly, currency can be had in its place.
Interest rate would have little effect on the ‘value’ of the currency as opposed to the ‘value’ the crude represents. Even without the crude aspect, deflation creates high ‘real’ interest rates which are opaque as deflation measures aren’t standardized.
“… quantitative easing is likely to induce what the late MIT economist Rudiger Dornbusch described as “exchange rate overshooting” – a large and abrupt shift in the spot exchange rate that occurs in order to align long-term equilibrium in the market for goods and services with short-term equilibrium in the capital markets.
This adjustment is depicted in the diagram below. In response to the monetary shock, a modest but long-term depreciation in the dollar (a rise in the U.S. dollar price of foreign currency) is required, depicted by the blue line. However, since nominal interest rates in the U.S. actually decline, ongoing equilibrium in the capital market requires that the U.S. dollar must be expected to appreciate over time by enough to offset the lost interest. As a result, quantitative easing is likely to result in an abrupt “jump depreciation” of the U.S. dollar (that is, a spike in the value of foreign currencies).Frankly, I’ve always thought Dornbush’s use of the word “overshooting” was unfortunate, because it implies that the exchange rate move is an overreaction, when that is not at all the case. Overshooting refers to the tendency of the spot exchange rate to move beyond its long-term PPP value, but this move is in fact approprate, efficient, and required in order to align the returns that investors can expect in each currency. So it is important to avoid misinterpretation – the policy of quantitative easing is likely to force a large adjustment on the U.S. dollar because the Federal Reserve is choosing to lay a heavier hand on the Treasury bond market than would result from economic conditions alone. The resulting shift in interest rates and long-term inflation prospects combine to dramatically reduce the attractiveness of the U.S. dollar. A significant and relatively abrupt devaluation is then required, in an amount sufficient to set up expectations of a U.S. dollar appreciation over time.
EDIT:
French government posits that driving in circles is a “fundamental freedom” sez the New York Times:
In his statement on Wednesday, Mr. Sarkozy said: “For millions of our co-citizens, transport represents a vital question. It is a matter of a fundamental freedom. In these last few days, many French people have seen their daily lives disturbed by the issue of supplies to some service stations.
“I gave instructions yesterday that all fuel depots should be reopened in order to re-establish a normal situation as soon as possible.”
To spare the gas stations, the cops roar in and break heads. Here is where the rubber meets the road: French drivers have priority over French pension benefits. I wonder what will happen when the shortages begin …
Meanwhile, the Chinese are using their stash of dollars to attempt to corner the potassium market. Fertilizers are made of three primary elements along with a host of ‘micronutrients’ in insignificant proportions. These three elements are nitrogen, phosphorus and potassium. These elements are vital to food production. They are elements and cannot be substituted for. Phosphorus and potassium can be recycled and will be as easily mined deposits are depleted.
Are the Chinese coming?
That’s the important question now being asked in Saskatchewan, a prairie province in Canada. It is also the question of the moment on Wall Street.
Saskatchewan is home base for the Potash Corporation, the fertilizer company. If you care at all about the future of the world’s food supply, you care — whether you know it or not — about Saskatchewan.
A consortium of state-backed Chinese companies and financiers may make a takeover offer for Potash that rivals a $38.6 billion hostile bid from BHP Billiton, and that prospect has lawmakers in Washington, regulators in Canada and bankers on Wall Street all talking.
The politically charged subtext is this: Do we really want the Chinese to control the company that has the largest capacity to produce fertilizer?
If that reminds you of 2005, when the China National Offshore Oil Company, or Cnooc, sought to buy Unocal, until an outcry from Congress stopped it, you would be right.
But that outburst of protectionism was only about the nation’s oil supply, and this would be about something much more vital, food: 45 percent of Potash’s production is sold to farmers in North America. The big worry, in part, is that the Chinese could seek to redirect that supply to China, starving other countries of a much-needed commodity.
Even for free marketers who say they believe that transactions should be able to cross borders without political constraints, the questions being raised in Saskatchewan and elsewhere are the ones that need to be asked.
Indeed, concern that politics may drive Chinese deal-making has grown amid recent reports that China has banned exports of rare earth minerals to Japan. Prime Minister Wen Jiabao of China has denied that the country has issued such a prohibition, but he acknowledged that the owners of rare earth metals may have halted shipments because of their own feelings toward Japan.
It’s hard to say how this will turn out, perhaps a trade; potash for rare earth metals …
Keep in mind that operations ‘owned’ outside a particular country’s borders are operations owned in name only. Nationalization by the host government with the operators skinned alive or burned at the stake is usually the next step after foreign ‘ownership’.