Consumer price inflation has started to diverge sharply in China and the US in recent months. Although this may be distorted by the higher weight given to rising food prices in China’s CPI data, it may also be due in part to China’s determination to keep the yuan down against the dollar.
The policy of currency intervention is starting to bring with it some definite costs for China, and their attempts to square the circle – keeping inflation low, while simultaneously keeping the exchange rate stable – can really only work in a controlled, non-market system. As China develops further towards a market economy, squaring this circle will become more and more difficult.
China’s monthly inflation data shows the headline rate of CPI inflation rising to 4.4 per cent in October, which is well above the comfort zone for the Chinese government. 
Some of this has come from higher food prices, which are rising at an annual rate of 10.1 per cent, but the non-food inflation rate has risen to 3.3 per cent, which is higher than occurred in the last inflation scare in 2007. The authorities have announced a combination of direct measures to hold food price inflation in check, such as caps on food price increases, and curbs on speculative activity. But these have not been very successful in the past.
Much of the rise in inflation in 2007 was due to a massive increase in pork prices, due to a disease in the pig population, and when this ended, inflation quickly subsided. This time, however, the rise in inflation seems to be somewhat more genuine, perhaps partly triggered by the easing in monetary policy which began in July.
But another reason for the rise in food prices is that the yuan has moved down against most other currencies in recent months, because it has been almost fixed against the tumbling dollar, and has therefore been dragged down with the US currency. This has led to a bigger rise in imported food prices, measured in yuan, than would otherwise have occurred.
By contrast, in the US, the Fed’s favoured measures of core inflation have been worryingly low in recent data releases. 
Ben Bernanke was recently criticised even by a member of the Fed’s FOMC for suggesting that core inflation was too low, but the Chairman will feel vindicated by the October core CPI figures, which show the level of prices, excluding food and energy, completely unchanged for the second successive month. The 12 month rate of core inflation rate is now at an all time low of 0.6 per cent, and even the headline rate (which includes food and energy) is only 1.2 per cent.
It appears that the disinflationary effects of the very weak domestic economy are more than offsetting the pro-inflation effects of a weaker dollar and rising commodity prices. All this clearly supports QE2.
Paul Krugman points out today in his blog in the New York Times that the combination of a trade surplus and rising inflation in China, along with a trade deficit and falling inflation in the US, strongly suggests that the yuan really is undervalued versus the dollar. Of course, the Chinese could retort that the real value of the yuan is rising because of the inflation differential, and that this is an alternative to allowing the nominal exchange rate to rise more rapidly. But this process works extremely slowly, while the problems faced by both China and the US are becoming increasingly urgent.
China is attempting to square its policy circle by using a panoply of non-market interventions – direct price controls, inward capital controls and foreign exchange intervention – all at once. Otherwise it could not tighten domestic monetary policy or hold inflation down while preventing much rise in the exchange rate down. But its huge economy is becoming more like a market system with every day that passes and interventionist economic policy may no longer work quite as well as it did in the past.
In any event, that is being severely tested by the inflation divergence which is developing between the two largest economies on earth.
