Inflation, Exchange Rates, and the Fed

The question came up today about how Federal Reserve action would affect other countries, and how this may differ in different countries.

Stephen noted that the Bank of Japan is fighting deflation by basically printing yen (buying bonds and releasing cash into the economy), trying to get people spending, and is worried about Fed action.  I speculated that the concern about the Fed lowering US interest rates would mean that more people would want to have yen, which would mean a stronger yen and more imports, which could in turn be deflationary.  Hence the worry.

Morten asked about why the Indian and Brazilian central banks would thus worry about inflation resulting from the Federal Reserve lowering US interest rates.  Certainly, we would expect that the Fed lowering US interest rates could lead to inflation in the US (though it has not yet), but we would not expect that for Brazil or India.  If anything, the Fed lowering interest rates for the dollar means that more people would rather have Brazilian reais or Indian rupees, especially if you can earn 12% interest in Brazil and only 0% in the U.S.

So what is the dynamic?  One possible answer is that the complaint from the Indian and Brazilian governments was not really about their own domestic inflation, but rather a worry about about their currencies appreciating and this hurting Indian and Brazilian competitiveness.  Keep in mind that what would be good for Brazilian consumers (and should, all other things equal, lead to lower prices for imported goods in Brazil and India) would be bad for exporters, as Americans and Europeans (and Argentines and Malaysians, etc.) would have less reason to buy Brazilian and Indian goods. So the worry might be less about inflation and more about economic growth.

Another possibility is that the demand for the Brazilian and Indian currencies would put downward pressure on interest rates in those countries (since so many Americans and Europeans want reais and rupees, Brazilian and Indian banks don't need to pay interest rates that are as high), whereas the governments want to keep interest rates high to prevent domestic inflation.

As noted in response to Randi's question the other day, there is a lot of "push and pull" in any of these issues.  A particular effect - such as an appreciation of the exchange rate leading to a reduction in inflation - might lead to a policy response such as a lower interest rate that then in turn depreciates the exchange rate.  So you come full circle in a sense, with the market "re-equilibrating", at least in theory.  

More on this as Morten posts his own follow-up.