NY Fed: Labor Costs & Inflation Drive Rapid Increase in Chinese Consumer Goods Prices

In a must-read article, the NY Fed studies the prices of Chinese imports into the United States and comes to some very interesting conclusions.  First, the basics:

We find that, in a sharp reversal of earlier trends, U.S. import prices for consumer goods shipped from China have been rising rapidly in recent quarters—by 7 percent between 2010:Q2 and 2011:Q1. 

Second, the authors explain that appreciation of China's currency appears to have had a direct and measurable effect on Chinese imports of commodity-intensive industrial supplies (e.g., steel), but had far less (if any) effect on consumer goods like the iPod:

[B]etween 1997 and 2005, when the RMB was pegged to the dollar, prices in all major categories of imports from China were on a downward trend. This trend reversed itself when the RMB was allowed to appreciate against the dollar in 2005.

By separating commodity-intensive industrial supply prices from other categories, we see that between 2005 and 2009 higher import prices of goods from China were mainly driven by jumps in industrial supply prices—goods that rely heavily on commodity inputs. Over this four-year period, consumer prices only increased 7 percent, even though the nominal RMB appreciated 20 percent against the dollar.

This pattern changed in mid-2010, when the RMB started to appreciate again. Import prices of consumer goods rose by 7 percent between 2010:Q2 and 2011:Q1, a period in which the nominal RMB appreciated 4 percent against the dollar and the CPI-adjusted real RMB appreciated nearly twice as much.

Third, the authors explain that labor costs and inflation, not RMB appreciation, are very likely causing the recent price increases for Chinese consumer goods imports:

Sharply increasing wages for Chinese workers and other escalating costs faced by Chinese firms in the country’s coastal manufacturing export hubs may be contributing to the rising prices of consumer goods shipped to the United States. Indeed, heightened unrest by workers demanding improvements in pay and double-digit wage-increase settlements have been making headlines in recent years (see, for example, Economic Times, New York Times, and Financial Times). Although data used to construct manufacturing unit labor costs are far from ideal, we estimate that wage-based unit labor costs resumed their upward trend in 2010 at the fastest pace in at least a decade, after dipping in 2009 due to a softening of China’s manufacturing labor market during the global economic crisis (see chart below). Moreover, the government enacted a major new labor law in 2008 that has likely driven up overall costs for firms.

Fourth, the authors discuss why economic growth and demographic issues will probably cause Chinese labor costs to keep rising, thus jeopardizing China's global dominance as a low-cost manufacturer:

Cyclical and structural factors are likely contributing to the rise in Chinese manufacturing unit labor costs. In particular, strong wage growth has partly reflected the very rapid cyclical recovery of Chinese manufacturing following the post-Lehman global trade shock, as well as the role of stimulus policy in generating greater incentives for migrant workers to stay closer to their home provinces inland rather than move to the coast to find jobs. Structurally, China is generally acknowledged to be undergoing a profound demographic shift to a rapidly aging society at an unusually early stage in economic development. China’s prime manufacturing cohort of people ages fifteen to thirty-nine has already peaked in size, and the United Nations projects that the working-age population as a whole will peak sometime over the next decade (see chart below). This implies that the days of seemingly limitless “surplus” labor supply may be nearing an end. And indeed, anecdotal reports of labor shortages in China’s coastal manufacturing provinces have surfaced periodically since at least 2003 (see, for example, Financial Times and “Chinese Workers Get Perks—Labor Shortage Spurs Firms to Court Factory Employees Pressure on Pay—and Prices,” Wall Street Journal, August 16, 2004)—about the time manufacturing unit labor costs started to rise....

Firms may be able to partially adapt to heightened labor shortages in China’s coastal manufacturing hubs by enhancing efforts to raise productivity and by moving factories inland, where labor remains considerably cheaper. However, over the longer term, the demographic shift facing China is real, as is the government’s desire to encourage faster household income growth, rebalance the economy away from investment and toward consumption, encourage the development of inland provinces, and develop higher-value-added industries. This suggests that while China’s days as the world’s factory may not be numbered, the prospect of continued rising prices of Chinese goods seems highly likely.

Finally, the authors explain what rising Chinese import costs will mean for the American economy (hint: it's not good):

More expensive consumer goods from China would represent a significant shift in U.S. inflation pressures, given China’s history of being a low-cost supplier of consumer goods to the United States. While it is difficult to assess the precise impact of changes in import prices on U.S. inflation, there are a number of channels we can identify. First, higher prices of imported consumer goods contribute directly to the U.S. CPI. Second, imported goods also enter into the production of domestic goods as some of these are intermediate inputs, which contribute directly to U.S. producers’ costs and thus add further pressure to increase the price of domestic goods. Third, higher import prices of Chinese goods may allow competitors, which include other exporters to the United States and domestic producers, to also charge higher prices and thus increase their mark-ups. Alternatively, competitors may try to gain market share by keeping their prices low and thus offset some of the inflationary pressures from the higher import prices of Chinese goods.

In short, higher Chinese import prices mean inflationary pain for American families and companies, and any lost Chinese market share will be replaced not only by domestic producers but also other foreign competitors.

Given all of these facts, why are American politicians attacking China's currency policies again?   To maybe help a few US companies who produce commodity-intensive industrial supplies, while definitely harming many more US companies, consumers and workers who directly benefit from low-priced Chinese imports?

Oh, right: they're doing it precisely because they're politicians.

(h/t Mark Perry)