Deflation, Fed Policy and Exchange Rates

The big story has been Ben Bernanke going to bat for Fed policy against both domestic and international critics over QE2. Domestically, the big fear is inflation. But the new inflation numbers (core CPI) show that inflation is at historic lows and going lower. The fear is that the United States is following Japan in into its own lost decade. The chart below from the New York Times shows this clearly.




























China has made it clear that it opposes QE2 because it will lower the value of the dollar, which will make it harder for China to maintain its huge trade surplus. In response to QE2, the Chinese Central Bank has raised its reserve requirements by half a percent (the Chinese Central Bank uses the reserves to buy dollars) which will negate the affect of QE2 plan. This is described in a good article in the New York Times. Here is an example of banking policy affecting exchange rates.