There was good news from the International Monetary Conference in Washington in mid-November when Federal Reserve Chairman Ben Bernanke discussed transparency reforms and reporting of the Federal Open Market Committee (FOMC). “Be still my heart” was not your reaction to this, but doubling the frequency from two to four times a year to provide projections on personal consumption expenditures (inflation), gross domestic product and unemployment rates – with a three-year time horizon – is a new method for the U.S. central bank to become public friendly.

Except for economists (and I’m an engineer), these are not exciting events. However, they are quite important for industrial outlook. Eighteen months ago, we anticipated these issues in contexts of globalization, wondering how the U.S. would respond to global imbalances of a falling dollar, employment and effects on unfunded liabilities like social security. Now the nation will have better insight. FOMC reports will be “narrative” for better understanding by Federal Reserve (FR) data users because the FR is charged by Congress to achieve two objectives – derive maximum employment and achieve price stability, both carrying equal importance. Mr. Bernanke said correctly that this increased openness enhances confidence in and effectiveness of U.S. monetary policy.

Most Americans do not appreciate the importance of good monetary policy and its proper management, which rests on the relationship between the various rates of interest in an economy and the total supply of money, using various tools to control one or both to influence outcomes like economic growth, inflation and employment. Modern nations use special institutions that exist solely for these purposes to execute policy independent of the “Executive.” That is why in the U.S., the Chairman of the FR is often called the most powerful man in the world. The FR uses “open market operations” as a primary tool to achieve specific goals and targets, principally using “federal funds rate” to control interest rates that member banks charge each other for overnight deposits. However, monetary policy of other nations may be different. China’s is to target the exchange rate between the renminbi and a basket of foreign currencies.

First, renminbi is the name of Chinese currency, just as the dollar is the name of ours. The slang word for this currency is the yuan and is equivalent to a buck or quid. In China, however, it is called a kuai. In order to achieve People’s Bank of China (PBC) goals, a technique known as “sterilization of capital flows” is used. This is a process that manipulates the currency relative to others. To ease currency appreciation, the PBC could encourage overseas private investment (recall the recent attempted 3-Com acquisition?) or use the classical form of sterilization – selling Treasury bills and bonds. Sterilization can be effective, but only for a limited time. Eventually, local currency gains undermine the competitiveness of export industries and domestic money supply rises without corresponding increases in the production base – inflation results. China has well over $1.5 trillion in sterilized renminbi and may be good to go for another year or two, but it is headed toward massive inflationary collapse.

The Chinese sterilization process is complemented by another intervention of the PBC – dollar-buying for the purpose of holding down upward pressure on the yuan. Today this intervention is so enormous and conducted over such a prolonged period that it is ever more difficult for the PBC to implement open-market sterilization operations. Forced underwriting of PBC bills upon Chinese commercial banks is quickly diminishing the sterilization option. With the massive buildup of foreign exchange reserves (which has been quite useful to the U.S. for financing its own debt), central banks around the world are pressuring China to appreciate its undervalued currency, which has risen in value about 7.5-9% since the last formal adjustment in July 2005. At the end of 2007, the current account surplus is estimated to be running about 11% of GDP and has immobilized nearly 25% of commercial-bank deposits. This is a formula for financial problems for China, and the PBC knows it.

In this game of financial chicken, it would be imprudent for the U.S. to blink and take punitive action. Let the Chinese blink. They soon will – to the world’s relief and advantage – when these monetary distortions normalize. Please remember to tell your Representative and Senators that it will happen without the U.S. Congress doing anything. Market forces are about to accomplish what politicians cannot.IH