China’s continuing efforts to curb inflation by increasing interest rates is, of course, important to Americans interested in exchange rate policy.
One point to make is that with differential inflation—faster in China than in the United States—the “real” exchange rate is changing faster than the nominal one. This means Yuan misvaluation isn’t really as bad as it seems. The flipside is that all this inflation trouble highlights the extent to which China’s refusal to revalue the Yuan really is bad for China and Chinese people as well as for American manufacturers. The most straightforward way for a country in China’s position to curb inflation would be to simply let the Yuan appreciate more rapidly. That would decrease demand for Chinese-made goods and stop the economy from overheating. It would also increase demand for goods made in the poor countries with which China competes—Bangladesh, Vietnam, etc.—and increase Chinese demand for American-made goods. Higher interest rates in the context of a fixed exchange rate is very much a “second-best” outcome.