The Impact of China on U.S. and Global Inflation

Will the slowdown in China’s growth keep inflation in check?

Inflation remains relatively low, both in the United States and globally, with the U.S. inflation rate hovering around the Federal Reserve’s 2% target.

Dropping oil prices and falling gas prices are big reasons, but these are always subject to fluctuation. Ebbing economic growth in China promises to be a much longer-lasting phenomenon, one that is more likely to help keep inflation in check.

What the Fed Thinks

A Federal Reserve policy statement on January 30, 2019 indicated that near-term U.S. inflation remains constrained. From the Fed:

In light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate to support these outcomes.

Good news for shoppers and borrowers as interest rates are not likely to rise dramatically anytime soon. How does that play into investment scenarios?

Inflation Today

Inflation, measured by personal-consumption expenditures, rose at an annualized rate of 1.9% in 2018, below the Fed target of 2%.

Interest rates remain low with the benchmark yield on 10-year Treasury paper at 2.75% in early March 2019. A 15-year fixed-rate mortgage clocks in at 3.96%.

Starting in the summer of 2018, Wall Street traders turned their eye toward trade discussions between the U.S. and China and the attention brought more volatility and, to some degree, a terrible December stock market, followed by 10 weeks of positive returns to start 2019.

Global money is flowing into the U.S. seeking better returns as the U.S. dollar has appreciated substantially against the yen and the euro, as well as other currencies. In fact, over the past 12 months, the U.S. dollar has risen more than 7% and is up about 1% in the month of February alone.

Since our dollar buys more, imports cost less in dollar-adjusted terms. Good news for lovers of imported French, Italian and Spanish wines and tourists headed abroad on holidays. The Fed likes a strong dollar up to a point, as it restrains inflation.

On the other hand, investors have to watch a potential race to the bottom as other countries consider devaluing their currencies to make their exports more attractive and imports from America less compelling.

China, Commodities & Inflation

Does China impact inflation here in the U.S.? While the answer is of course complicated, the fact that China continues to shift from a catalyst for higher prices in commodities needed to fuel its growth to a more subdued tempo, could help hold down inflation worldwide, including in the U.S.

For the past decade, China was on a tear building infrastructure – roads, railways, airports, and real estate. By one estimate, China used more cement in the last three years than the U.S. consumed in the entire 20th century.

One result of China’s building boom was that economies that produced basic materials such as coal, copper, iron ore, nickel and aluminum benefited significantly from Chinese growth, as China was a net importer of basic commodities. Australia was a prime beneficiary, as were African countries.

In addition, these investments in fixed capital propelled China’s economic growth, i.e., manufacturing capacity, infrastructure, residential and commercial real estate. This resulted in excessive investment, debt expansion and overcapacity in some sectors.

Aware of this risk, however, China’s leadership moved away from a fixed-capital intensive growth model to something more balanced, such as encouraging more in-country production and consumer buying. That should produce subdued pressure on commodity prices, another influence in restrained inflation.

Invest In or Against China?

The China story continues to fascinate as money managers and investors search for growth stories. China is now the world’s largest auto market as it is over 12-times larger than the British car market, almost double the entire EU markets combined and ten million sales more than the United States market, which is the second-largest new car market in the world.

Yet China suffers from overcrowded roads, big city congestion and extreme air pollution problems at times, offering both challenges and openings for opportunistic companies.

The ongoing battle between yin and yang continues. U.S. gross domestic product growth, at a 2.6% annualized clip in the fourth quarter of 2018, cheered investors and attracted global capital flows.

With low interest rates likely to continue, investors have to balance risk and reward in seeking investments that will grow in excess of inflation and taxation.

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