Bickering US And China Play Blame Game

If the U.S. and China were dating, this is what they would be saying to each other right now: 'It's not me, it's you.'

As so often, money worries are the source of tension in this relationship; in particular, inflation. Neither party wants to accept responsibility for it, preferring instead to wait for the other to cave.

How this game of chicken plays out will define the global economy in the second half of this year.

To Beijing, rising commodity prices owe much to the Federal Reserve's continuing campaign against disinflation through quantitative easing and zero interest rates, undermining confidence in the dollar.

While QE has boosted financial-asset prices, though, U.S. house prices remain moribund and unemployment, while improving, remains high. For the Fed, the economic recovery remains fragile and spare capacity counteracts inflationary forces.

The Fed in turn points the finger at China's rampant appetite when it comes to rising raw materials prices. Under this argument, China's economy remains too wedded to fixed investment and exports, abetted by an artificially depressed yuan. A higher yuan would help make Chinese exports less competitive and encourage a shift towards a less resource-intensive consumer and services economy, as well as easing the cost of dollar-denominated commodities.

If Beijing won't countenance that, then Chinese inflation is the logical outcome and is also useful to Washington, as it makes Chinese exports less competitive.

Both positions have some merit. It is remarkable that QE continues nearly two years after the end of the U.S. recession. Higher real U.S. interest rates would take some heat out of commodities prices, especially if raised in tandem with central banks elsewhere, many of which are also running loose monetary policy.

Yet if the U.S. can be accused of playing with inflationary fire to bolster employment, so is China. Beijing's long-standing linkage of the yuan to the dollar and enormous injection of stimulus into the economy in the wake of the financial crisis both predate QE.

Recent measures, such as pressuring Unilever to postpone price increases, demonstrate the acrobatics required by Beijing to cool inflation if traditional monetary methods aren't used.

China is unwilling to raise rates sharply or let the yuan appreciate quickly because that would hurt big export industries and state-controlled borrowers with close ties to Beijing, says Diana Choyleva of Lombard Street Research. And price controls, while effective in the short term, encourage consumption and supply shortages in the medium-term, stoking inflation.

So the pressure on China looks intense. Slow to withdraw the stimulus deployed during the financial crisis, Beijing now struggles to contain rising prices with gradual, often unorthodox, methods. Fed policy and supply shocks like Middle Eastern turmoil compound the pressure.

And, unlike America, China is grappling with wage inflation due to demographic changes and still faces the risk of elevated property prices.

Sharp jumps in the cost of living have been associated historically with social turmoil in China. Beijing is, therefore, caught between fear of inflation squeezing incomes too hard and higher rates, or a stronger yuan, hurting growth and boosting unemployment.

The current course of policy makers pleases commodity bulls while making life difficult for the Fed, which must explain away headline inflation as a temporary phenomenon.

But, with inflation a more clear and present danger in China, expect Beijing to blink first.