Unlike US and Europe, China can keep its economy steady without rushing into lower interest rates

Flat CPI inflation is a mark of the Chinese government’s success in navigating the energy crisis, keeping core inflation pressures contained
Beijing should maintain policy stability for interest rates and the renminbi, and let fiscal reflation take the strain of economic recovery

David Brown

Published: 10:00pm, 17 Jul 2023

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Deflation in China, or the risk of negative consumer price inflation, is no reason for Beijing to panic. If China’s headline inflation rate does dip down into negative territory or stays close to zero per cent, where it’s been stuck over recent months, it’s simply the flip side of higher energy prices unwinding from last year, a statistical phenomenon that economists call base effects, when slower price rises this year are compared with faster price gains 12 months ago.

If anything, zero per cent price inflation is a mark of China’s success in navigating the energy crisis, keeping core inflation pressures well contained and staying competitive.

There’s no pressure for Beijing to cut and run with lower interest rates again as mainland recovery should gain traction from earlier policy eases, supporting the government drive to hit 5 per cent growth this year. Consumer and business sector confidence will pick up as global uncertainties diminish and, if there is any need for extra economic stimulus, more government fiscal reflation, especially in big-ticket public infrastructure projects, would be the best way to achieve it.

As the economy bounces back from last year’s tough Covid-19 restrictions, growth could even surprise on the upside this year, leaving the People’s Bank of China reasonable scope to keep interest rates steady for the rest of 2023.

To be fair, with China’s headline inflation rate dropping from a modest high of 2.8 per cent in September last year down to zero per cent in June this year, it’s no wonder observers are worried that the slowdown in price rises may be more to do with a fundamental lack of demand in the economy and the recovery running out of steam.

In fact, on a relative basis, China has an enviable track record when it comes to growth and inflation performance compared with some of its major international competitors, especially in the G7 economies. China’s inflation rate may be undershooting Beijing’s 3 per cent CPI target, but it still has a better relative growth record with no chance of recession.

Contrast this with the United States and Europe, whose central banks have struggled to contain near double-digit inflation, forcing interest rates sharply higher, and raising recession fears in the process. In the US, inflation has fallen from last year’s peak of 9.1 per cent down to 3 per cent in June, but the spectre of recession lingers.

In Europe, euro area growth prospects have been dented by a dip into technical recession after two successive quarters of output falls, with inflation still stuck at 5.5 per cent in June after hitting a 10.6 per cent peak in October last year. The European Central Bank still has a score to settle with inflation, leaving more rate rises on the cards later this year.

But this is nothing like the stagflation nightmare that the United Kingdom faces right now, with headline inflation stubbornly stuck at 8.7 per cent in May while underlying core inflation was still rising to 7.1 per cent, its highest level since March 1992. The Bank of England is sabre-rattling for even tougher monetary policy, causing UK mortgage rates to rise to their highest level in 15 years.

It’s tough on UK consumers, bad news for the housing market and even more ominous for economic growth prospects in the coming months. The UK cost of living crisis is a disaster in the making.

Shoppers at a fruit and vegetable stall in Bexleyheath, Greater London, on June 19. UK consumers are facing high inflation and a mortgage rate that is the highest in 15 years. Photo: Bloomberg

By comparison, the options facing Beijing’s economic policymakers seem like a cakewalk. The key is not to get drawn into a rush for lower interest rates. Deflation in China is less a proxy for weak growth than a signal that global prices are generally starting to stabilise.

If there is a concern about the prospects for faster recovery, where there is a potential demand gap is the weakness in business activity abroad, reflected in the 12.4 per cent year-on-year fall in China’s exports in June. Policy-wise, Beijing has little leverage on these flows while global demand remains weak.

There is no sense in letting the yuan exchange rate weaken through lower interest rates to gain any extra competitive advantage. But there is a risk that with the US Federal Reserve’s monetary tightening coming to an end soon, US dollar weakness might signal a return to a stronger yuan. If China’s import prices soften much further, this would strengthen deflation expectations.

The key message for Beijing is to maintain policy stability for interest rates and the currency, and let fiscal reflation take the strain of economic recovery going forwards.

David Brown is the chief executive of New View Economics