2008 February 01 Friday
China Inflation Spilling Into United States

For a few years now I've held the view that foreign buying of US bonds was causing a weak US currency, cheap imported consumer goods prices, the large US trade deficit, and inflation of housing and capital prices. But the conditions that caused this state of affairs are coming to an end. Prices are rising in China and causing higher prices in the US.

Soaring energy and raw material costs, a falling dollar and new business rules here are forcing Chinese factories to increase the prices of their exports, according to analysts and Western companies doing business here.

The rise was a modest 2.4 percent over the last year. But even that small amount, combined with higher energy and food costs that also reflect China’s growing demands on global resources, contributed to a rise in inflation in the United States. Inflation in the United States was 4.1 percent in 2007, up from 2.5 percent in 2006.

Because of new cost pressures here, American consumers could see prices increase by as much as 10 percent this year on specific products — including toys, clothing, footwear and other consumer goods — just as the United States faces a possible recession.

Welcome to the 1970s flashback era of stagflation.

Place this in context. For a few years Alan Greenspan has been saying he sees an eventual resurgence of US inflation on the horizon. I've never heard him say why. But put this in context. We've had a huge run-up in oil prices for a few years without a recession (at least until now). We underwent too much monetary expansion. But the monetary expansion didn't cause consumer price inflation because we were getting flooded with cheap Chinese goods and the Chinese were using their trade surplus to buy US bonds to keep their currency weak and the prices of their goods low in the US. The monetary expansion did cause an inflation in housing prices and other more durable asset prices.

Well, all that was not sustainable. Hence the recession. Economist Martin Feldstein at Harvard says the housing asset price inflation enabled American consumers to borrow against their equity to keep their buying power up even as energy prices rose.

MF: In the post-World War II period, recessions have been preceded by a combination of increased oil prices and high interest rates. And we certainly got a dose of both of those this time. The Fed raised the federal funds rate from 1 percent to 6 percent, and oil prices tripled. So yes, I would have been worried that that combination alone, driven by the high oil prices, could have turned us down. In fact, I wrote a piece in the Wall Street Journal a couple of years ago, asking: Why did the jump in oil prices (that we had then observed—from roughly $20 to $60 a barrel) not push the economy into recession? And I answered that by saying: because there was this surge in home-equity borrowing that allowed individuals to increase their consumption faster than their incomes. I concluded by saying that if energy prices continue to increase, we cannot count on that kind of offset from higher consumer spending financed by mortgage borrowing.

Feldstein says that the US recession probably isn't going to cut into China's or India's economies. This means that total world oil demand probably won't go down as much as US demand if world demand even goes down at all.

MF: I don’t think that India and China are going to be adversely affected by a slowdown in the United States, if it occurs. Now, that’s different from having them pick up the slack, to use your phrase, and provide aggregate demand for the rest of the world. I think those two ideas get confused sometimes when people talk about decoupling. India does not depend on exports to the United States. Similarly, I think the direct impact on [U.S.] imports from China would not be that large. China exports a lot, but its net exports (when you net through how much it imports in order to reexport) are not so much a driving force in their economy, and they have other ways of picking up the slack domestically. In fact, they’ve been worried about the fact that their economy has been growing too fast, and they’ve been looking for ways to dampen it. If their exports slow down, they will shift toward more domestic spending. That’s a very good thing for the Chinese economy and may make for a structural change that will reduce the future trade imbalance between China and the United States. So, I don’t think the Chinese should be that worried about a U.S. recession.

Since oil prices probably won't slacken and prices of goods from China are on the rise a recession in the US will not eliminate 1 source of inflation in the United States while inflation of goods prices from China will add another source. Plus, the US dollar will decline against the Chinese currency adding to that price inflation.

The US has been living beyond its means. This inflation of consumer prices is part of the process of lowering living standards that is needed to bring us back within our means.

Share |      By Randall Parker at 2008 February 01 11:06 PM  Economics Trade


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