Change in China's policy could cause dollar to fall and US interest rates to rise (at least temporarily)

I am convinced that Brad Setser discovered a new trend in his July 14 blog posting "The mystery deepens. China’s June reserve growth is surprisingly low". According to Setser, Chinese reports indicated that the Chinese government purchased much less foreign currency in June than in previous months.

There were two possibilities: Either the June data was a fluke or the June data represents a new Chinese policy. My first inclination was to suppose it was a fluke, but I just read a Financial Times article which reports that the Chinese consumer price inflation fell the same month to 7.1% from 7.7% in May.

Combine that with Dr. Yu's overview of the Chinese economy where he advocates strong measures by the Chinese government to counteract inflation, and I think that Brad Setser was the first to spot a real change in Chinese policy! So long as China sees a need to fight inflation, they may plan to greatly slow their foreign exchange purchases.

China had a choice if it wanted to fight inflation. It could either reduce the amount that it was lending to foreign countries (which would cause its currency to strengthen, thus reducing its exports and increasing its imports) or it could reduce the amount it was lending to its own citizens. In June, they apparently decided to reduce the amount they were lending to foreign countries.

There has been some grumbling about the decision to tighten credit. The Financial Times article reports: "(T)he central bank is under growing pressure from different parts of the government and industry to relax some of the tightening measures, which could increase with the latest signs of slowing growth."

Some in China want the government to resume buying ever more foreign currency. The same article reports: "In particular, the Commerce Ministry called last week for slower appreciation of the currency."

It appears that Chinese inflation is causing the Chinese government to pause its mercantilist attacks upon foreign countries. I would expect a rise in the yuan, a fall in the dollar, and a rise in US interest rates as a result of this new (possibly temporary) Chinese policy.

Howard