Remarkably, the best predictor of US inflation expectations during the past three years is the RMB’s exchange rate against the US dollar. That’s because the marginal item bought by an American consumer with the $6 trillion of pandemic stimulus handouts is likely to be imported, and likely to be imported from China. China’s exchange rate affects the prices of so much of America’s goods consumption that the RMB moves inflation expectations in the US.
The regression fit of the RMB exchange rate against the 5-year 5-year forward inflation rate is 80%. More importantly, it is significant at the 99.99% confidence level in a first-difference regression, which means simply that the likelihood is vanishingly small. that the relationship is spurious
Of course, the reverse also is true: The RMB is a hedge against US inflation. Chinese bonds pay a positive real yield (the 5-year Chinese government bond yields about 2.5% with an inflation rate of around 1%, while the US 5-year note pays 1.9% with an inflation rate of 7.5% and a 5-year expected inflation rate of about 3%).
Higher US inflation pushes capital out of the US bond market and into China, and that strengthens China’s currency. The RMB is a long way from competing with the dollar as a global reserve currency, but the fact that the RMB and China’s government bond market provided a hedge against dollar inflation shows its potential to replace many functions of the dollar in the not-too-distant future.
The inflation expectation measure that tracks the Chinese currency most closely is the US five-year inflation swap five years forward, which measures the expected inflation rate (on average) over the five-year period that begins five years from today. Economists and traders favor this as a gauge of long-term inflation expectations, because it filters out transient price shocks.
US imports , and especially US imports from China, soared after the US government paid $6 trillion in stimulus payments to US households. Between January 2020 and December 2022, total US imports rose by 21%, but imports from China rose by 37%. American consumers to an increasing extent spent their marginal dollar on something made in China.
The price America paid for Chinese imports fell through most of the 2010s, along with the RMB’s exchange rate against the dollar, but turned sharply upward after the Covid-19 pandemic. Durable goods inflation was almost absent during most of the past dozen years but has become a big contributor to inflation in the past 24 months.
The point to take away from this quick review of the data is that the American economy is so integrated with China that China has become the marginal price-setter for large parts of the US economy. The Trump tariffs on a wide range of Chinese imports failed to slow, let alone reverse, America’s dependence on China. The United States doesn’t have the capital stock or skilled labor to meet a surge in demand, and Americans paid up for Chinese goods because they couldn’t get them anywhere else.