Vice-President, Chief Economist and Strategist
Where China Has Turned an Ally: Combatting Inflation
When it rains, it pours in China. This week, we learned that the country’s exports suffered a larger-than-expected drop in July. The 14.5% slide was also the biggest since February 2020, although this figure is a bit amplified by base-year effects. That was only the latest in a string of disappointing developments out of China. Q2 GDP growth missed expectations by a meaningful margin and the details were bad, showing ongoing deterioration in a wide range of subcomponents, including consumption and the property sector. And of course China is facing a host of other challenges, such as Western trade restrictions and climbing youth unemployment. Compounding these issues is the persistent downward trend in foreign direct investment inflows as multinationals reconfigure their supply chains. We were always skeptical of the narrative that China’s reopening would save the global economy this year. So far, there isn’t much proving us wrong.
But China’s woes are ironically helpful in the fight against inflation. The unique inflation circumstances in China, where producer and export prices are in deflation, are reverberating externally. Since China is a major global manufacturing hub, the price decline is influencing import price indexes in countries reliant on Chinese imports. For instance, Canada's recent international trade report noted the largest monthly drop in import prices since 2017. This weakening trend now extends beyond just commodity components to also encompass consumer goods—the third-largest import category behind energy and vehicles. Between December and June, import prices in this category have declined by over 2%.
These shifts align with our findings that advanced economies' excess inflation is less driven by global factors and more influenced by domestic forces. Import price pressures are estimated to have accounted for up to half of domestic demand inflation for the most part of 2022. So it turns out that China is an ally in the inflation fight—or at least more than a federal government turning a deaf ear to calls for some moderation in the pace of newcomer admissions. While we agree that demographics matter for long-term public finance sustainability, we have argued that failure to put smart boundaries around non-permanent admissions comes at non-negligible short-term costs.
Be that as it may, the Bank of Canada is likely comfortable with the current degree of monetary tightening for the time being. Could the recent pickup in oil prices become the proverbial fly in the ointment? While central banks will keep the seven-week-and-counting oil price rally on their radar, we don’t believe there is cause for significant concern yet. The move higher follows Saudi Arabia’s extended output cut, coinciding with robust US economic data and the consequent bets of a soft US landing. Weaker backdrops in Europe and China tend to offset a more upbeat US outlook, however. Moreover, OPEC’s oil supply management faces limits against US shale producers signalling higher production for the remainder of the year as they make productivity gains. As a result, the rally doesn’t rest on a firm fundamental footing, and fears of a new leg of energy-driven inflation seem premature. In the case of Canada, there’s some room to run before gasoline starts contributing positively again to year-over-year inflation. Base-year effects make this scenario unlikely before late 2023 at the earliest.
In the meantime, September will mark 18 months since the beginning of the current hiking cycle, meaning we’re about to enter the period of peak tightening impact. As our analysis has shown (here and here), mortgage renewals will relentlessly erode households’ discretionary spending capacity, further exacerbating the ongoing rise in financial strain.
Broadening weakness should catch up to wages, as July's surprise jump in pay growth raised chatter that another hike may be in play. A more accurate interpretation is that wages are lagging behind previous job market tightness. Against that noise, the true signal lies in job cuts—which in some cases are reversing prior excess hiring—along with falling overtime hours and fewer job openings. Employers are increasingly perceiving labour as less scarce, foreshadowing eventual wage growth moderation. All of this may hold promise for those longing for lower interest rates. But that’s only because recession signs look likely to become more apparent going forward.
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