Chinese Deflation Is Unlikely to Pass Through to US Consumer Goods Prices

Summary

• The ongoing deflation in the price of US imports from China should moderate as it is based on sharp and unsustainable CNY weakening rather than on productivity gains.
• China’s influence on global export prices is set to weaken as the global trade system fragments and China’s role diminishes.
• US consumer goods prices have already become driven more by fast-growing domestic costs than import prices.

Market Implications

• The market underestimates the terminal Federal Funds Rate (FFR).

Chinese Import Price Deflation to Moderate

Since the pandemic, US import prices from China (hereafter Chinese import prices) have been falling (Chart 1). This begs the question of whether the pre-pandemic trend of Chinese import price deflation will resume and whether it will again be accompanied by US core consumer goods price deflation. I argue that the answer to both questions is ‘no’.

Since the mid-to-late 2010s, China’s import price deflation has reflected currency weakness that is much less sustainable than the productivity gains that drove the import price deflation of the early 2000s.    

This is shown on Chart 2. It compares the price of imports from China in USD and CNY. It shows a marked increase in CNY costs since the pandemic, offset by sharp CNY depreciation. 

This is confirmed by a recent increase in China’s relative goods prices. Chart 3 displays the implicit deflator derived from the ratio of the BIS nominal to real effective exchange rates.  The ratio measures China’s goods prices relative to that of its trade competitors (see BIS for full methodology description).

Chart 4 shows further evidence of lost Chinese efficiency – a sharp decline in China’s ratio of exports to GDP. China’s opening to global trade was the key driver of its growth acceleration in the 1990s and 2000s, and its reversal suggests a less efficient allocation of resources and much slower productivity gains.

Lastly, the mid-2010s is also when China’s share of world exports stabilized (Chart 5). A jump in China’s global export share in 2020-21 reflects the collapse of world trade and does not appear sustainable.

By contrast, the global export share of China’s new competitors (India, Vietnam, Malaysia, and Bangladesh) has kept rising while that of its ‘old’ competitors (Singapore, Korea, and Taiwan) remains stable. 

China’s struggles with productivity gains and global competitiveness is also consistent with  the country getting caught in the middle income trap. China has likely already crossed its Lewis point (i.e., run out of surplus rural labour to be re-allocated to the more efficient manufacturing sector). Some academics believe it did so as soon as 2010, though the IMF sees it ‘almost certainly’ between 2020 and 2025.

This has left Chinese productivity growth dependent on the efficiency of the labour, goods, and financial markets. China’s falling openness, inefficient financial sector, and widespread government interference with market mechanisms suggests productivity driven export price deflation is unlikely to resume anytime soon.

This leaves China’s export competitiveness dependent on currency weakness. Since the peak in the USD price of US imports from China in April 2022, CNY has depreciated by more than 10% against the USD, and by 8% on a trade weight basis (using the BIS effective exchange rate).

The Chinese authorities are unlikely to allow for CNY depreciation at the current pace. This would risk destabilizing FX markets by generating one-sided expectations. In addition, China now faces political obstacles to the expansion of its exports. In this context, the stimulative effects of a weaker CNY could be limited. Finally, a long-term decline in CNY would have a negative wealth effect for holders of CNY assets and increase the CNY value of the foreign liabilities of Chinese corporates.

But even if I am wrong and China has embarked on a long-term campaign to cheapen its currency, its impact on overall global prices may not be as pronounced as before the pandemic.

Global Import Prices to Decouple From China

The correlation between Chinese import prices and import prices from other countries has been weakening, and I expect this to continue for two key reasons (Chart 6).

First, the global trade system is fragmenting, due to rising geopolitical tensions and rising protectionism. In my opinion, this weakening started pre-pandemic, as shown by the stagnation of global trade relative to global GDP after the GFC (Chart 4). It could be that, while China had become less competitive, the world had run out of cheap places to relocate to. Few countries could match China’s late 1990s combination of cheap workforce, good infrastructure, political stability, and scale. The weakening of the global trade system can also be seen with the greater dispersion of global export prices (Chart 7 shows the SD of export prices across the Euro-area, US, UK, Japan, China, emerging Asia ex China, Eastern Europe, Africa, and the Middle East). This dispersion spiked around the GFC but fell afterwards. The dispersion also spiked during the pandemic but has increased since.

Second, at least for the US, the share of China in total imports is falling (Chart 8).

Finally, rising US protectionism implies less influence from Chinese import prices on goods inflation.

US Goods Prices to Be Driven by Less Efficient US Producers

The impact of globalization on US goods inflation is shown on Chart 9. Up to the late 1990s, CPI, PPI, and import price of core consumer goods were running at a similar clip. But starting in the late 1990s, PPI inflation decoupled from import price inflation, import prices flattened and the goods CPI tracked import prices.

But the pandemic cut out global supply chains and led to a decrease in imports (Chart 10).  The decline in the share of imported consumer goods continues, possibly due to protectionism that started well before the pandemic. In addition, car imports collapsed and have yet to recover.

As a result, consumer goods prices started to track the PPI more closely than import prices.  Current bipartisan consensus against China and in favour of protectionism suggests these trends could continue.

Market Consequences

The changes described in this note have profound market implications. Short term, they suggest the current MoM consumer goods price deflation is likely to prove transitory. As a result, Federal Reserve (Fed) expectations that core PCE will fall by close to 1.5 percentage points in 2024, which would allow for four rate cuts in 2024, could be disappointed.

Long term, they imply a higher structural inflation in the US. As a result, the Fed may have to choose between a higher inflation target or higher long-term unemployment. I do not expect this complex debate to get settled anytime soon, but I at least expect that the Fed will struggle to get back to a 2.5% long-term FFR.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed, the IMF, and the World Bank. She joined Macro Hive soon after its inception.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)