An overvalued currency can come back to earth in two ways. The value of the currency vis-a-vis other currencies can decline, or the value of the currency vis-a-vis goods can decline: nominal depreciation or inflation. We understand that China's State Council has told the People's Bank of China not to let the nominal value of the RMB rise. But why hasn't there been substantial domestic inflation in China? It is an offense against the Gods of Monetarism for the PBoC to be able to target both the nominal exchange rate and the nominal price level--to keep the value of the currency low on foreign exchanges and the value of the currency high vis-a-vis goods as well.
Brad Setser writes:
RGE - Inflationary real adjustment in China?: Chinese inflation seems to be picking up. That is a good thing. If China insists on holding the value of the RMB down -- and if the RMB's pace of appreciation against the dollar is slow, so the RMB in practice is depreciating against a host of currencies that are appreciating faster than the RMB is against the dollar -- the only way China's real exchange rate can adjust is through a rise in inflation.... Indeed, the biggest surprise coming out of China -- and there have been many -- is that rapid money growth hasn't, at least until now, generated much inflation.
A DBS report (See Chart 1 on p. 2) shows that China has had Philippine style money growth over the past ten years without experiencing Philippine-style inflation. Indeed, the average inflation rate in China over the past ten years looks substantially lower than the average inflation rate in the US. Even with inflation above 3%, China isn't appreciating all that rapidly in real terms. US and European inflation isn't that much lower.... I would rather see more nominal appreciation across the emerging world. But in countries whose real exchange rate is undervalued, rapid inflation is a logical consequence of resisting nominal appreciation.