Paulson, Bernanke Meet Chinese Inflation Wall: William Pesek
June 11 (Bloomberg) -- Henry Paulson and Ben Bernanke, consider yourselves boomeranged.
A year ago, U.S. Treasury Secretary Paulson was using virtually every chance he had to urge China to strengthen its currency. The effort has gone full circle with China calling on the U.S. to worry about its own.
``We have conveyed to the U.S. government that a strong U.S. dollar is in the interest of the U.S. economy,'' Zhu Guangyao, an assistant minister at China's Finance Ministry said last week.
That turn of events is even more extraordinary than the yuan's 11 percent gain against the dollar in the past year. The dollar is clearly getting on Asia's nerves. Aside from hitting the region's competitiveness, the trillions of dollars of reserves held in Asia are losing value by the day.
Another implication is that the Treasury has been outmaneuvered by China. When he created the twice-a-year ``strategic economic dialogue,'' Paulson might not have anticipated China turning the U.S.'s tactics back at officials in Washington.
``We're seeing this effort by the U.S. to devalue its way to economic growth,'' says Randall Kahn, managing partner at Apiana Investments in Tokyo. ``The problem is it's not going down well in Asia.''
Bernanke's Boomerang
Federal Reserve Chairman Bernanke's boomerang experience may prove more serious.
Economists have long warned that the Fed's 3.25 percentage points of interest-rate cuts since September complicated China's inflation woes. Much of the liquidity from the Fed's rate reductions has made its way to Asia, boosting money supply and fueling inflation.
Now there's reason to believe the Fed is suffering from those same feedback effects -- importing inflation that's ultimately of its own making.
Even though China is letting the yuan rise, it's still closely linked to the dollar. It's not a formal peg, like those in the Gulf, yet China keeps the yuan on a short leash relative to the dollar.
The question is when the so-called dollar zone becomes influential enough to affect global inflation and the Fed's latitude to cut rates further. One wonders if we have already reached the point where the Fed's liquidity is, in a very roundabout way, heading back to the U.S.
1930s Perspective
Bernanke is well versed in the lessons of the 1930s, when policy makers were too slow to head off a massive U.S. economic decline. Hence his aggressive rate cuts and role in saving Bear Stearns Cos. Yet what has changed in the seven decades since the Great Depression is the global role of the Fed and the dollar.
The Fed operates with the U.S. in mind. It often gets away with downplaying the U.S.'s imbalances -- like a current-account deficit that would sink other nations -- because it prints the reserve currency. That's why the Fed felt it could go so far to restore calm on Wall Street.
In a more closed economy, central bankers don't have to worry much about their peers overseas. When your economy is as big and open as the U.S.'s, when capital markets are more porous than ever and when trillions of dollars are warehoused abroad, monetary-policy dynamics become more complicated.
The dollar's implications haven't escaped Bernanke. He said last week the Fed is ``attentive'' to the currency's effect on inflation expectations. The shift in rhetoric fits with Paulson's effort to put a floor under the dollar.
Peg Hypocrisy
Paulson may not fathom how the dollar is complicating the Fed's job. He recently traveled to the Gulf and voiced confidence that dollar pegs in economies such as Saudi Arabia, the United Arab Emirates and Bahrain aren't going away.
Never mind the hypocrisy of all this -- it's a problem for China to peg its currency, but fine for Gulf states. Paulson's bigger concern is heading off a broad-based and destabilizing shift from the dollar into the euro.
A continued buildup of dollars comes with its own risks. As seen in China and in the Gulf, the increase in reserves is overwhelming policy makers' ability to keep them from seeping into the money supply. It's hardly a good time for such a dynamic amid record food and oil costs.
While explosive world demand is driving commodity-price trends, so is cheap money, says Harvard University Professor Jeffrey Frankel. Low U.S. rates are encouraging speculation in commodities, while the rising value of those commodities simultaneously boosts inflation and lowers borrowing costs.
Trichet's Rate Threat
Negative real interest rates in Asia also are bumping up against oil subsidies in nations such as China. When put together with undervalued currencies and policies that keep oil prices higher than they should be, inflation rates above gross-domestic- product growth are a problem. So is the likelihood that the dollar's declines are feeding demand for oil.
It's not clear what to do about all this. With European Central Bank President Jean-Claude Trichet threatening to raise rates, the Fed's dollar options are limited. Intervening in markets also seems of limited utility. Besides, the Treasury is technically in charge of dollar policy.
What is clear is that patience with the dollar is running out, and not just in China. The U.S.'s days of devaluing its way to growth may be over.
(William Pesek is a Bloomberg News columnist. The opinions expressed are his own.)
To contact the writer of this column: William Pesek in Singapore at wpesek@bloomberg.net
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