NEW YORK – Earlier hopes that China had beaten deflation took a hit this week.
China’s consumer prices rose just 0.5% year-on-year in July, down from June’s 1% rate — the slowest pace in six months and the third straight month of deceleration, despite surging energy prices amid Strait of Hormuz disruptions. Producer prices slowed too, rising 3.5% year-on-year in July versus 4.1% in June.
Few are less surprised by this than Yale economist Stephen Roach. “However 2026 shakes out, hopes Xi’s team is successfully deflating China’s deflation could be in for a rude awakening,” he says. “Japan’s example shows that even if headline data suggest that reflation is afoot, the deflationary mindset is very hard to change.”
The bottom line, Roach argues, is that “deflationary pressures can persist long after headline inflation turns positive, quietly eroding confidence. That’s why markets are buzzing about the possibility of People’s Bank of China easing in the months ahead — a move that could weaken the yuan and widen China’s trade surplus.”
That surplus is the unspoken subtext, according to Brad Setser of the Council on Foreign Relations. “Of course, no one explicitly says they would welcome a bigger surplus,” he says.
“But if an international institution’s policy advice is monetary easing — to fight deflation — and fiscal consolidation because of off-balance-sheet risks, plus more exchange rate flexibility, it is effectively advocating for the country to export its way out of its domestic troubles.”
Yet Beijing has resisted letting the yuan slide. A stable or appreciating currency serves three strategic aims: reducing offshore default risk among heavily indebted property developers; supporting yuan internationalization, a long-term goal to elevate it as a reserve currency; and managing tensions with Washington, where the Trump administration remains highly sensitive to any hint of competitive devaluation.
Right now, a firm yuan also helps China avoid importing even more inflation. The harder problem, as Roach warns, is psychological — and Japan has spent decades proving how stubborn that psychology can be. Recent data reflect “stalling reflationary momentum,” notes Union Bancaire Privée economist Carlos Casanova.
In the short run, he says, it’s notable that the data show “weak domestic demand,” retail sales “remaining contractionary,” and “fading commodity cost pressures,” at least for now.
Casanova says that the PBOC itself has highlighted “growing structural divergence, with AI-related sectors outperforming even as broader consumption remains sluggish. Subdued credit demand also further limited monetary transmission.” That leaves scope for a 25 basis-point cut in the reverse repo ratio.
Setser is skeptical that currency policy is doing much of the work either way: “There’s no evidence that the nominal depreciation of 2022-2023 materially reduced the pace of deflation in China, and also zero evidence that the modest nominal appreciation of the last year led to a faster pace of deflation. If anything, the pace of deflation has moderated, though I fully accept that higher oil prices have had something to do with that.”
Still, many fear the PBOC is behind the curve. Société Générale economist Michelle Lam notes that “China’s growth likely cooled notably in the second quarter to 4.4% as weak consumption and property activity outweighed resilient exports and a modest quarter-end industrial rebound.”
She adds that “while producer-led reflation supported nominal growth, policy easing is likely to remain incremental rather than a precursor to large-scale stimulus.”
The bigger question is just how incremental. Japan’s long struggle shows how stubborn deflationary psychology can be to defeat: though Japanese consumer and producer prices are rising, households still lack the confidence to increase spending enough to hasten economic growth or lift business confidence over the long run.
For Chinese President Xi Jinping, the most urgent reforms are resolving a chronic housing crisis that increasingly resembles Japan’s 1990s bad-loan spiral, and building a real social safety net so 1.4 billion citizens feel confident enough to spend rather than hoard savings.
These priorities are tightly linked — with roughly 70% of household wealth tied to property, stabilizing the real estate market across China’s 70 biggest cities is essential to reviving consumption and sustaining 4.5%-5% economic growth.
The longer Xi’s government lets these pressures fester without decisive action, the more a deflationary mindset takes hold — and the harder it becomes to shake.
Japan remains the cautionary tale. Even as the Bank of Japan struggles to lift short-term rates above the current 1% level — the farthest from zero in more than three decades — deflationary undercurrents still run through the economy, particularly in wages, which continue to lag inflation.
The result has been a slow-burn form of stagflation, and Tokyo has yet to deliver the structural reforms needed to close the gap between rising prices and stagnant household incomes.
Toshihiro Nagahama, economist at the Dai-ichi Life Research Institute, argues that for Japan “to fully break free from its long-standing deflationary mindset, it’s imperative for the government and the central bank to align, articulate their risk assessments, maintain honest and transparent dialogue with financial markets, and resolutely execute bold, long-term growth investments.”
Nagahama speaks for many when he argues that today’s global economy is being reshaped before investors’ eyes by wars in Ukraine and the Middle East, alongside a series of historic turning points in central bank policies amid rising global inflation and a strong dollar.
Amid so much uncertainty, governments can’t anchor their strategies to hopeful scenarios — they must instead plan around worst-case risks, including the possibility of a multi-year disruption in the Strait of Hormuz, a chokepoint that would reshape global energy flows and inflation dynamics.
“While these shifts present a formidable trial for Japan, they also represent a historic opportunity,” Nagahama notes. “As the country sheds its decades-long deflationary mindset and restores nominal growth, these external shocks serve as a critical test for fully escaping the paradigm of contracting equilibrium.”
Back in China, the gap between surging producer prices and muted consumer prices is now the widest since June 2022. That divergence suggests manufacturers are struggling to pass higher input costs on to consumers, leaving profit margins under pressure.
If that squeeze persists, it could have serious implications for wages across a $21 trillion economy, undermining household spending and complicating Beijing’s reflation narrative.
This China “deflation trap” problem worries geopolitical experts like Eurasia Group CEO Ian Bremmer. The concern, he says, is that Team Xi continues to “prioritize political control and technological supremacy over the consumption stimulus and structural reforms that could break the cycle. Beijing has the means to prevent a crisis, but living standards will deteriorate, the fallout will spread abroad, and the world’s second-largest economy will remain stuck in a trap of its own making.”
The plunge in home prices since 2020, Bremmer warns, means “household wealth destruction on par with America’s 2008 crash, except it’s still accelerating.” Consumer confidence, investment, and domestic demand have cratered with it. “Beijing,” he adds, “bet big that high-tech manufacturing would fill the gap left by property. Instead, state-driven investment has created overcapacity, and weak domestic demand means there aren’t enough buyers to absorb it.”
The good news is that Xi’s Communist Party is working to turn the nation’s $28 trillion stock and bond markets toward funding its chip rivalry with the US. This means moving away from subsidies and state backing toward a model closer to Xi’s pledge to let market forces play a “decisive role” in economic decision-making.
The worry, though, is that cracks in the underlying financial system — China’s “old economy” — limit the growth of the new one Xi aspires to create.
Roach worries that with Xi “fixated on a growth model that draws unsustainable support from innovation, new technologies, and other trappings of what they now call new quality productive forces,” he’s only “paying lip service to Chinese consumption but unwilling to take the big steps required of consumer-led rebalancing.”
As Japan taught the world, Roach says, “the problem was not so much its technological successes but the sustainability of its growth model.” He adds that the “same lesson might be very much applicable to China,” at a moment when the Chinese growth model is “showing unmistakable signs of sputtering.”
For now, China is focused on halting the capital outflows leaving mainland stocks. In recent weeks, it reactivated the so-called “national team” of state-owned investment funds Xi’s party mobilizes to boost the markets. What’s needed, though, are bold steps to revive economic confidence in the longer term, which are currently in short supply.
Follow William Pesek on X at @WilliamPesek
