Thoughts on Disinflationary Implications of China's Slowdown

Many observers see the open-ended commitments of the Fed and ECB as setting the stage for future inflation. Others retort that the output gaps remain sufficiently large that sustained price pressures are unlikely to be seen for some time.

The kind of inflation that excessive monetary easing would create is a demand shock as investors fearful of the debasement of paper money flock to things, that as Dennis Gartman pithily put it, hurt when you drop on your feet. The sharp rise in food and energy prices appear to be more a function of supply shocks rather than demand.

The rise in the price of foodstuffs was triggered by poor weather combined with low inventories. In fact as the USDA recent estimates were not as poor as expected, some food prices have fallen. Dec corn, for example, peaked in early August and today is trading more than 12% lower and its lowest level in nearly 2-months.

Oil prices also seem to reflect supply issues or concerns. Iran, for example, is still the center of many concerns. Incidentally, this week, more than two dozen countries are conducting coordinated naval exercises aimed at countering possible responses to Iranian action should it retaliate to a strike as it has threatened.

There are powerful dis-inflationary forces emanating from the economic slowdown in China. It is not simply from the demand side, as many observers seem to suggest. To appreciate the supply component, one must recognize that 1) in China capacity for various products has outstripped demand and 2) that Chinese businesses have relatively high fixed costs.

What follows from these two largely uncontroversial observations is that Chinese companies will have be more aggressive in substituting foreign demand for the weakening domestic demand and, given the need for cash flow, will produce and sell at a loss, if necessary.

This is exactly what is happening to the steel industry. Slowing construction and industrial activity more generally has seen China's absorption of its output fall and this is forcing exporters to be more aggressive. Most immediately this is seen squeezing other low cost producers, like those in Turkey and Russia.

A Reuters report indicated that the Chinese discount to Russian and Turkish steel has doubled in recent weeks. Chinese producers are also reportedly penetrating the hot rolled steel market in Europe, which tend to focus production on specialty steel. US anti-dumping laws are reportedly shielding the US to some extent. China has requested consultation with the US under the auspices of the WTO to discuss US steel duties.

Competition is becoming more fierce in third markets, like the Middle East, North Africa and Latam. What is happening in the steel market may take place in a range of other industries. The US just filed its second complaint at the WTO about China's subsidies to the auto and parts industry.

The incorporation of China into the global economy would be a challenging event in any circumstances. However, it is all the more difficult when China experiences a slowing of domestic demand.

Slowing domestic demand forces it to export more or risk greater social unrest. The increase in exports "borrow" others countries' aggregate demand causing trade frictions, even as it may blunt some of the inflationary pressures. One other implication of Chinese practices is that it shows that while it can be a great friend to developing countries, it also is a rival.