The Shanghai Composite was happily trading as high as 3187 last week before the Chinese inflation numbers came out. After it was reported that inflation in China had accelerated to a two-year high (and likely was going higher), the Shanghai Composite fell expeditiously to 2825 in just five trading days — this is a huge move in a very short time frame.

As for the details, consumer inflation in China rose to a 4.4% annual pace in October, up from 3.6% in September. Food and energy account for a higher proportion of consumer prices in China and observers now anticipate China’s central bank will raise key interest rates to deal with this inflation problem, which is likely headed to at least 6%. Not a single economist expected for October inflation to come in that high, so the sharp reaction in the stock market is one of traders reacting to the surprise data — a classic knee-jerk reaction.

One solution for China to help control the inflation spike is to let the renminbi appreciate faster against the dollar. Essentially, to fight deflation in the U.S., the Federal Reserve is creating inflation in China via the pressure that QE2 and other Fed measures put on the commodity markets.

The U.S. CPI Index has a real estate component that includes owners equivalent rent and related shelter categories that is over one-third of the CPI index. Actual house prices were included prior to 1983, but were removed as rents were more stable. Now, to fight weakness in this huge component of CPI, the Federal Reserve is creating inflation in other components of the same CPI index. In effect we have asset price borderline deflation and commodity inflation in the U.S.

When you put it all together we have a U.S. CPI index that is barely rising — even though it feels like prices are rising when you head to the grocery store or fill up your car.

I am not sure the way to fight weakness in housing is to create inflation in everything else. This is because the credit mechanism that supported the U.S. housing and commercial real estate market is not operating properly. The total amount of credit available in the U.S. system is still down from its 2007 high due to the collapse and the following weak revival of debt securitization. With less credit available, housing and commercial real estate prices are weak. Plus, there is less demand for the weakened availability of credit. You can see how rising inflation in some components of the CPI does not directly affect the real estate related components that the Federal Reserve is worried about.

The Fed’s actions do, however, affect inflation in China. This is because of the very different weights in the components of Chinese and U.S. CPI. When you talk about inflation in the U.S. and in China measured by CPI, you really are talking about apples and oranges. If you look at a chart of the Chinese CPI year-on-year change and then look at a chart of the CRB commodity index that is overweight oil (as opposed to the equally weighted one which is even higher), you will notice many similarities.

This is because commodities feed through much faster in the Chinese CPI Index than they do in the U.S., as this article mentions.

Many of the G20 members are increasingly viewing the U.S. as a currency manipulator and are unhappy that a weak U.S. dollar is boosting worldwide commodity prices. Given that commodities are a bigger part of inflation gauges and consumer spending in emerging markets, it is easy to see why they are protesting.

I think it will be difficult to stop this surge in inflation in the developing world as money tends to flow towards the best destinations for returns. Due to the broken financial system, instead of flowing into U.S. real estate, it flows into Asian real estate where the financial mechanism is healthy. It also goes into commodities, commodity stocks like Vale (NYSE: VALE) and BHP Billiton (NYSE: BHP), gold and silver bullion investable via the SPDR Gold Trust (NYSE: GLD) and the iShares Silver Trust (NYSE: SLV) as well as Asian and other emerging market equities.