Stephen King: A weak currency doesn't equal higher inflation

The message was brutal: Better to keep your job with a pay cut than to have no job at all

I spent last week in Asia. As you'd expect, there's a lot of concern about the dollar. The majority view seems to be that the dollar will weaken, notably against the euro, pulled down by the weight of America's current account deficit. But there's a lot more uncertainty about the consequences of dollar weakness. In particular, there are widely differing views on the outlook for US inflation. Some people regard dollar weakness as a harbinger of renewed inflationary pressures. Others doubt that there's any relationship at all between currency movements and inflation rates.

I spent last week in Asia. As you'd expect, there's a lot of concern about the dollar. The majority view seems to be that the dollar will weaken, notably against the euro, pulled down by the weight of America's current account deficit. But there's a lot more uncertainty about the consequences of dollar weakness. In particular, there are widely differing views on the outlook for US inflation. Some people regard dollar weakness as a harbinger of renewed inflationary pressures. Others doubt that there's any relationship at all between currency movements and inflation rates.

I suspect that people's views are coloured by age. Those whose economic views were formulated in the 1970s and early 1980s will have grave doubts about the ability of domestic inflation to withstand the influence of exchange rate movements. Those, however, whose formative economic years were in the 1990s are likely to have very different views. Did UK inflation rise when sterling left the ERM in 1992? No. Was there a sustained rise in inflation expectations in Mexico following the peso's collapse at the end of 1994? No. Has the US dollar's decline since early 2002 led to much higher US inflation? No, at least not yet.

In the old days - a world populated now only by econometric models - it was very difficult for countries to benefit from exchange rate shifts. A fall in the exchange rate would be followed by higher import prices, higher domestic inflation and, inevitably, higher wage demands. Thus any initial competitive benefit associated with an exchange rate decline would rapidly be eroded through a rise in domestic prices and wage costs.

Not any more. The evidence increasingly suggests that increases in import prices - whether the result of a weaker currency or because of higher commodity prices - have little, if any, impact on domestic inflation expectations. The charts show that the impact of commodity price and oil price shocks on domestic US inflationary pressures has steadily fallen over the past 40 years. No longer is it easy to claim that a given increase in import prices - whether through higher global commodity prices or through a softer currency - will have a large, and damaging, impact on US inflationary pressures.

Why is this? Workers - whether acting as individuals or forming unions - have lost their ability to demand compensation for real income losses associated with higher import prices. In part, this loss of worker power reflects more mobile capital. If you walk into your employer's office and demand a pay increase as compensation for an increase in oil prices, the chances are that the employer will simply outsource your job to some other part of the world where labour is cheap but, at the same time, reasonably well-educated (both India and China spring to mind).

Another factor is the increasing mobility of labour. America went through a demographic shock in the 1990s when its population swelled through the immigration of Hispanics from south of the border. Europe may be going through its own version of this process today with its informal labour market - construction workers, au pairs - increasingly expressing itself with a Slavic lilt. Inevitably, this process injects some extra flexibility into the domestic labour market.

A very good example of this story is Germany's 2004 experience. Here was a country used to centralised collective wage bargaining, a country that was institutionally fearful of external price shocks because of the implicit threat to wage and price stability. With oil prices rising rapidly, Germany - and the European Central Bank - started to fret. Yet, the wage response was highly unusual, at least relative to earlier oil price shocks. Companies, faced with the prospect of lower profits, simply told their workers that their wages would have to fall. The message was brutal but effective. Better to keep your job with a pay cut than to have no job at all.

There is, of course, an important additional factor. Public acceptance of price stability and the emergence of independent central banks now imply that external cost shocks simply won't be accommodated. The monetary framework is such that neither workers nor companies expect to see wage and price increases being sustained. With this framework, it's almost impossible to imagine a return to the inflation of the 1970s, when governments ran the monetary show in a fairly clueless way.

The bottom line is that nominal exchange rate adjustment these days may also imply real exchange rate adjustment. Econometricians don't like this sort of conclusion because it implies that changes in a nominal variable - the exchange rate - can have lasting effects on real variables - output, real incomes. If you like, it's an international version of the old arguments that suggested a trade-off between output and inflation. In both cases, you have to fool people into believing that something "real" has happened instead of the monetary equivalent of Pepper's Ghost.

There's no doubt, though, that our policy makers do believe that nominal exchange rate movements will have real effects. The US administration, for example, has been happy to allow the dollar to fall over the past two years and the Federal Reserve has, more recently, provided extra encouragement to those who want to sell the US currency. It's fairly easy to see why. Many US policymakers now accept that the US balance of payments position is spiralling out of control. To correct it, either foreign demand has to rise strongly, US demand has to weaken dramatically or the dollar has to fall a long way. Ideally, the US would like to see stronger foreign demand but a weak dollar is a useful "second best" alternative.

More generally, the G7 has increasingly expressed its frustration at the lack of currency flexibility in countries and regions elsewhere in the world. The most obvious culprit, at least in American eyes, is China, where the renminbi has been steadfastly fixed against the dollar for more than a decade. China, though, may provide the best example of the limitations of nominal exchange rate adjustment. It's hard to believe now but, only four years ago, financial markets believed that China would devalue the renminbi, a response to the Asian crisis and China's loss of competitiveness against its Asian competitors.

China's exchange rate devaluation did, in fact, take place but via movements in domestic prices, not the nominal exchange rate. China went through a period of deflation, pushing wages down and, therefore, restoring competitiveness after the earlier losses associated with the collapse of other Asian currencies. In China's case, the truth is that workers are paid so little - and prepared to work for so little - that no amount of nominal exchange rate adjustment is going to make a lot of difference to China's longer-term competitive dynamics with the rest of the world.

So, there are limits to the degree to which nominal exchange rate adjustment will foster real exchange rate adjustment. Nevertheless, the past 15 years' experience makes it easy to see why industrialised countries now regard nominal exchange rate movements as an important part of the international economic adjustment process. The problem, though, is that any exchange rate movements will have to be handled with great care. After all, they're simply a mechanism designed to achieve relative price adjustments between countries. Back in the 1930s, they were called "beggar-thy-neighbour" policies. It doesn't take much to realise that reliance on forced exchange rate adjustment is not a million miles away from protectionism.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com