It's a good thing that Chinese workers don't have to eat....

Markets are remarkably subdued so far this week, perhaps suffering from "crisis exhaustion" after last Friday's payroll data. The investment bank earnings releases that had originally been scheduled for early this week (Bear and Lehman) have been pushed back into next week. Perhaps that's an ordinary occurrence, or perhaps it's a sign that they're struggling to fit the pieces together in a SarbOx-compatible fashion. If the latter, it's not exactly a ringing endorsement that the worst is over, is it?

As is generally the case, China marches to a somewhat different drumbeat to the rest of the world. So while the West has been snoozing, it's been all action in China with the release of a (yet another) higher-than-expected CPI report and a 4.5% decline in equities. While the latter is but a blip, the former has now reached its highest level in more than ten years, and thus merits some attention.

As has been the case throughout the year, food prices account for the bulk of the rise in CPI. Non-food-price inflation remains fairly steady at around 1%, which has encouraged many China watchers to presume that the current bout of inflation need not be met with aggressive policy tightening. Just as Clara Peller asked "Where's the beef?" in the 1980's, the question here appears to be "Where's the pass-though?"
Is that the right question, though? After all, a number of non-food items (energy, most conspicuously) fall under the aegis of price controls and thus should not be expected to show a price rise. And given the number of Chinese citizens living on a subsistence or quasi-subsistence basis, it is surely not in the best interests of a regime focused on stability to see food inflation (which has now hit 18.2%!) foment unrest in the hinterland.

And even relatively well-off urban workers must feel the pinch of food prices. Hell, the price of bread exceeding £1 per loaf made front page news in London! But the ease with which many seem to disregard food prices makes it seem as if Chinese workers don't have to eat. In fact, nothing could be further from the truth; food comprises a much higher proportion of living expenses in China and other developing economies than in the developed world. As such, food price inflation should be more likely to feed through into wage demands in these countries than one would expect in the US, Europe, or Japan. And higher wages could, ultimately, overwhelm productivity gains and generate higher unit labour costs from erstwhile disinflationary producers. Perhaps it's already happening, given recent trends in US import prices from China.

Further evidence that the inflationary dynamic in China may be more potent than commonly believed comes from the Baltic Dry Index, a well-known measure of freight costs. The rise of the last eighteen months has been little short of parabolic. In a sense, it doesn't matter how little it costs to produce something in China (or Vietnam, or India.) If it costs an arm and a leg to ship it, that's what the price will be in the destination market.
It may seem foolish to fixate on Chinese inflation when the Fed has finally ceased to care about US inflation. But if the Chinese authorities decide to meaningfully tighten macro policy after the October Party Congress, Asia might not be as bullet-proof as commonly supposed. And if Chinese unit labour costs do begin to rise in a meaningful way, the inflationary consequences of a weak dollar bubble could be that much more extreme.

Macro Man's systems have gone haywire, so no P/L today.
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Anonymous
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September 11, 2007 at 12:53 PM ×

But isn't passthrough from a weaker dollar to CPI rather limited? I believe there is an SF FRB paper on this from 2004 that estimates passthrough to be < 10%. Perhaps the relationship has changed since then?

Thanks for the response to the spot/forward FX question I asked.

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Dan
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September 11, 2007 at 5:54 PM ×

I am glad that you are considering "higher unit labour costs" in china only from a inflation perspective in USA

Some believe the high labour costs could bring back manf jobs to usa. Thats is joke isnt it ?

Dr. Dan

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Macro Man
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September 11, 2007 at 7:18 PM ×

I suspect that passthrough from a bubble of dollar weakness, wherein he dollar is expected by all and sundry to weaken ad infinitum, would be greater than implied by the FRBSF.

Any manufacturing jobs that relocated from China would be more likely to relocate to Mexico than the US.

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Anonymous
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September 13, 2007 at 6:43 AM ×

An interesting comment (albeit somewhat off-topic from your post today) from N. Roubini's blog:

I attended a meeting hosted by the British Bankers Association in the City yesterday on the credit crunch. There was very little optimism that it could play out soon or smoothly. The US and UK have grossly misallocated excess credit towards residential real estate and consumption, making it virtually impossible that the mountain of debt owed by consumers and financial institutions can be repaid with a reasonable risk-adjusted return.

The consensus was that the Fed had indulged the markets too generously after the dot com bust and 9/11, fueling the asset bubbles that will painfully unwind in months to come. LIBOR is still spiking - and sustaining its spike over Fed funds. Hedge funds are coming under redemption pressure and as more close redemptions will dissuade further inflows. Banks are retrenching to build capital for reserves and to fund committed lines of credit that will now inevitably be drawn down due to the seizure of the commercial paper market.

In short, the conditions for a massive repricing of credit are in place and soon folks are going to notice that the Fed's "happy talk" no longer delivers properity. Whatever the base rate, the rates charged by banks to consumers and corporates are heading higher.

Governor Mervyn King's letter today makes clear that imprudent bankers will get bitter medicine and no sympathy from the Old Lady. I read the letter as being addressed more to the Fed and ECB than to the Parliament Treasury Subcommittee, laying down the law that the Bank of England would not be complicit in further rigging of the credit markets against good sense and rational pricing of risk.
Written by London Banker on 2007-09-12 17:42:06

Peace,
P. Lumumba

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Macro Man
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September 13, 2007 at 7:47 AM ×

Thanks. That actually fits in with some of the issues being discussed in the comments section of the next post. I'd concur with much of what is written there, albeit with the proviso that monetary conditions in the UK are likely tighter than in the US and Europe, and thus there is a greater economic rationale for loosening here than there.

But 'tis true, I was pleased to see Swervin' Mervyn take a stand against the provision of moral hazard to credit markets.

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