Dollar weakens against the yuan

Most observers are cheering China's decision over the weekend to allow its currency to once again appreciate against the dollar (top chart), and I agree that it is probably a good thing, if for no other reason than that it reduces the risk that U.S. politicians will screw things up by starting a trade war with China.

But it's also a good thing for China itself, since a stronger currency reduces the risk of higher inflation, which was already uncomfortably high and rising (second chart). A stronger currency will also lead to higher Chinese living standards, since the purchasing power of Chinese incomes will rise in proportion to the yuan's rise against other currencies.

But instead of focusing on the stronger yuan, I think the real focus should be on the dollar. What the Chinese are doing is withdrawing their support of the dollar—effectively voting against the dollar. They were buying dollars and otherwise accumulating reserves in order to keep the yuan pegged at 6.83 to the dollar. If they hadn't taken enforced the peg, then presumably net capital inflows would have driven the yuan higher at the expense of the dollar. So now they will buy fewer dollars and allow the yuan to rise. (I made some more extensive comments on the history of the yuan's link to the dollar here, but in rereading the post I note that my conclusion—that the Chinese would only revalue if the dollar weakened further, which it hasn't—was wrong.)

The Chinese decision also highlights the dollar's fundamental weakness. Being pegged to the dollar meant that China experienced the full effects of U.S. monetary policy. Rising Chinese inflation is strong evidence that the Fed has been too easy, and that the dollar has been too weak. Chinese inflation is like the canary in the coal mine for U.S. inflation—monetary policy acts faster in the Chinese economy because it is much smaller and more dynamic. Plus, trade is much more important to the Chinese economy than it is to the U.S., so changes in the value of the yuan, which have been primarily driven by changes in the dollar's value, flow through to the general price level faster in China than they do in the U.S.

By revaluing against the dollar, China will experience a tightening of monetary policy. And, by reducing the demand for dollars, China's action will result in a further easing of U.S. monetary conditions. Therefore, inflationary pressures in China will diminish, while they will increase in the U.S.

I doubt that this decision will prove to be of great benefit to U.S. exporters, but it should be of some benefit on the margin since a stronger yuan will make all imports cheaper for Chinese consumers. One collateral effect of this is that Chinese demand for commodities will strengthen, and that is likely to push commodity prices higher over the long run.

China's decision is likely to be detrimental to U.S. consumers since the prices of Chinese imports will tend to be higher than otherwise. But that is just another way of saying that what really happened today is that U.S. monetary policy has effectively become easier—through a weaker dollar—and that will eventually increase U.S. inflation. Higher U.S. inflation, in turn, will tend to drive Treasury yields higher.

At the very least, this decision adds to the reasons why deflation is not a serious risk. And to the extent that deflation is not a risk, that brightens the outlook for the U.S. economy, and, in turn, for risky assets in general.