China’s Deflation Makes Jerome Powell’s Job Harder

As Federal Reserve Chairman Jerome Powell plots the next move by the most powerful central bank, he might want to confer with officials in Beijing.

China slipped back into deflation in October. A mild drop into the red, admittedly—consumer prices fell just 0.2% year on year. But students of Japan’s 1990s will remember that it’s best not to downplay such inflection points.

As Chinese officials head to San Francisco, they can expect to be peppered with questions about Beijing’s plans to avoid a prolonged deflationary funk. Not since the late 1990s, arguably, has an Asia Pacific Economic Cooperation summit been more preoccupied by Chinese weakness than its strength.

The last time, again arguably, was in 1997 when the APEC circus unfurled its tents and communiques in Vancouver. That was amidst the chaos of Asia’s financial crisis, and wow was it a frenetic scene. Surreal, too.

At the time, I was a young Washington-based reporter covering the Fed and U.S. Treasury Department. I’d just spent a week in Hong Kong, where the International Monetary Fund held its annual meeting. There, U.S. and IMF officials scrambled to keep turmoil in Indonesia, South Korea and Thailand from spreading—especially to China.

The worry at the time was that Beijing, too, would devalue its currency. That, officials feared, would kick off a fresh race to the bottom on exchange rates. And pull nations like Malaysia and the Philippines into the brink, too.

This explains why, days earlier, then-Treasury Secretary Robert Rubin and deputies Lawrence Summers and Timothy Geithner stopped in Beijing to discourage Chinese leader Jiang Zemin from tossing lifter fluid on an already raging financial fire.

China didn’t devalue, thankfully. But a month later, when Asian officials landed in Vancouver, worries about China devaluing to prop up the economy followed then. Adding to the sense of doom in the air: worries that Japan, then Asia’s biggest economy, would be pulled into the crisis.

The 1997 APEC confab had barely begun when news broke that Yamaichi Securities had collapsed. The spectacular demise of the then-100-year-old institution, one of Japan’s fabled big-four brokerages, absolutely panicked officials gathered in Vancouver. None more so that Rubin and his boss President Bill Clinton.

The days to come saw Clinton and fellow Asia-Pacific leaders cajoling then-Japanese Prime Minister Ryutaro Hashimoto to get a handle on Tokyo’s financial system. All the while, officials there also kept a firm watch on China’s intentions.

The events of 26 years ago are instructive as APEC again hits the North American west at a moment of maximum paranoia about Chinese fragility. Fresh signs of deflation hardly help.

No member of the financial intelligentsia has more riding on China’s trajectory than Fed leader Powell. As he prepares for San Francisco, Powell is reminding markets that the Fed won’t hesitate to hike interest rates again if conditions warrant.

A disproportionate number of those conditions may rely on China, where growth is slowing almost as fast as risks of debt defaults are rising.

Few serious economists are betting on a Chinese crash. We can debate whether 10 years of Xi Jinping’s leadership have left the second-biggest economy better off. What’s not debatable is that Team Xi is skilled at circling the financial wagons and taming runaway markets.

Still, China’s property market is clearly in crisis. The fact it can generate as much as 30% of gross domestic product makes the sector a clear and present danger to local government finances. Hence Beijing’s pivot from championing deleveraging to ramping up fresh stimulus.

The calculus for Powell is knowing the point where too much Fed tightening becomes a major threat to developing economies, including China.

In 1997, the Fed’s fingerprints were all over Asia’s reckoning. It was the dollar’s rally following a hyper-aggressive 1994-1995 tightening cycle that destabilized Asia. Over time, currency pegs in Bangkok, Jakarta and Seoul became impossible to defend.

The dollar’s current rally is luring capital that Asia desperately needs to finance growth and cap bond yields. The Japanese yen’s tumble to 33-year lows is one data point. So is a 5.5% drop in the yuan this year. Further declines would make it harder for China’s property developers to make payments on offshore debt.

China exporting deflation is perhaps the last thing the global economy needs. And it’s a data point that Powell and fellow Fed policymakers must consider very cautiously.

Yes, the Fed conducts rate policies in America’s best interest. And it’s far from clear where the Fed might take rates next. The latest from Powell is that his team is proceeding “carefully.” Some Fed governors, including Michelle Bowman, a governor at the Fed, suggest another rate hike is needed to ensure inflation moves toward the 2% target.

Fair enough. But tipping China into deeper turmoil might boomerang back on the U.S. in dramatic ways. Powell would be wise to increase China-related surveillance efforts. Trouble in China will rapidly show up on America’s economic shores, too.