A tale of two inflations

People love complaining about inflation, however, few find it a particularly interesting topic. Like your blood pressure can give the doctor a pretty good sense of your overall well-being, inflation can tell us a lot about the underlying strength of an economy.

The past week saw the release of inflation data from both the US and China, the world’s largest two economies. In both cases, the data was slightly lower than expected, but it still tells the story of very different economic dynamics.

Starting with China, core inflation has been running below 1% for most of the past three years. Core inflation excludes food and fuel prices that are volatile and can distract from the business of understanding underlying inflationary and economic processes.

Chart 1: China and US core inflation

Source: LSEG Datastream

Weak inflation points to some combination of weak demand or excess supply. Japan went through a long period of persistently low (often negative) inflation over the past 25 years. Other developed countries experienced stubbornly low inflation after the global financial crisis. The pandemic and subsequent inflation surge have seemingly jolted North America, Europe and even Japan out of this low inflationary torpor.

China, on the other hand, did not experience a post-pandemic inflationary episode, and instead seems to be belatedly experiencing its turn of low inflation. The common denominator across these very different economies and their episodes of low inflation was private sector debt and a real estate bubble. Japan’s property bubble burst in 1990. In the West, the end of the subprime bubble almost sunk the North Atlantic banking system in 2008.

China’s giant property sector has been experiencing a painful correction since the government introduced the “three red lines policy” in 2020 to rein in leverage, particularly among developers. While it has been successful on its own terms, officials at the time did not necessarily realise the extent of the collateral damage they would cause.

Not only is sales and construction activity way down, but predictably, house prices have fallen (though they probably have not been allowed to fall as much as would be the case in a free market). The property implosion has severely dented confidence among Chinese consumers, since homeownership rates are high by global standards at around 90%. It is also the main vehicle for long-term savings, instead of retirement funds or equity portfolios. As many households feel a lot poorer, they are reluctant to spend.

For local governments, land sales to developers was a big source of income that has now largely dried up. As a result, they are cutting back on services and employment.

A weak property sector is not the only reason behind low inflation. Beijing’s policy response also matters. Interest rates were tweaked lower, and there have been some support packages aimed specifically at the property sector. The main thrust of intervention has rather been aimed at stimulating advanced manufacturing – “new quality productive force” as the policy is termed – such as electric vehicles, batteries and semiconductors. But with domestic demand still tepid, increased industrial output only serves to put further downward pressure on prices. Of course, one avenue for this excess production has been exports. Export growth has been solid, but other economies are increasingly pushing back, even if cheap Chinese imports helps keep inflation down. The US imposed steep tariffs on Chinese electric vehicles a few weeks ago, and the European Union has made similar noises.

The lesson from burst property bubbles in other countries is that the process of working through the overhang of excess inventory and excess debt takes time, usually years. Eventually, however, time heals all wounds, and that includes wounded balance sheets.

Policy can speed this process up, but so far support for the property has been targeted and limited. This week will see Communist Party brass convene for the Third Plenum, a key policy-making forum for the next few years. While many commentators are calling for a large stimulus plan to kickstart domestic demand, this seems unlikely. The focus will probably remain on sectors deemed strategic from a national security point of view, and ongoing management of debt levels. Therefore, there is still no consumption boom on the horizon.

Reflecting the expectations for lower future inflation and interest rates, Chinese government bond yields have fallen substantially over the past three years, meaning bond prices have risen. The yield on the 10-year Chinese government bond yield has fallen from 3.3% at the start of 2021 to the near record-low levels of 2.2% today. More recently, the rally in Chinese bonds has been driven by speculative buying, partly because property and property-linked investments are out of favour. In fact, the People’s Bank of China has intervened in the bond market to calm things down.

Chart 2 shows how Chinese bonds have outperformed equities, while the opposite has been true in the US. US equities have been flying (apart from big drawdowns in 2020 and 2022) while bonds have endured a torrid time since it became clear in 2021 that the Fed would have to embark on a major hiking cycle. From the start of 2021, the 10-year US bond yield rose from 0.9% to 4.3%.

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