China is falling into deflation

Tariffs are a deflationary shock for big net exporters to the US like China

Much has been said about how tariffs are an inflationary shock for the US. That’s indubitably true, especially as the Dollar fall amplifies any rise in import prices. But - unlike COVID - tariffs are not a shock that’ll push up inflation around the world. The opposite is true. As a big net importer of goods, the US will have a positive impulse to inflation. In contrast, big net exporters to the US like China, the Euro zone and Japan are facing a deflationary shock, as goods that previously would have been shipped to the US gather dust in warehouses. It’s not easy replacing US demand with domestic buyers or find other places to export to, which means there’ll be downward pressure on prices in net exporter countries. The global inflation picture is about to diverge.

In Monday’s post, I used S&P Global Purchasing Manager Index (PMI) data to show that this divergence is starting to play out in data. US manufacturing firms are hiking prices they charge consumers, while there’s no such indication for the Euro zone. In a way, my focus on the Euro zone buried the lede. After all, it’s China that has borne the brunt of tariffs, while also being the single biggest goods exporter to the US. If there are deflationary pressures, they should be most pronounced for China.

The left chart shows supplier delivery times (black), input prices (red) and output prices (blue) for the US. Delivery times measure disruption to supply chains, input prices are what firms pay suppliers and output prices are what they charge customers. I’ve transformed each of these into Z-scores for comparability across series and countries. The Z-score transformation means you can think of a reading of 1.9 - which is where US output prices now are - as two standard deviations above “normal,” a sign inflation pressure is building.

The right chart shows the same three series for China. You can see the spikes in delivery times during various COVID lockdowns. The Z-score for output prices is currently -1.6, which means there’s deflationary - not inflationary - pressure. To be sure, deflationary pressure has existed for some time as China grapples with excess capacity in its manufacturing sector. But it’s notable that this deflationary pressure shows no sign of abating.

China’s headline CPI inflation was -0.1 percent year-over-year in April 2025. The deflationary impulse from US tariffs is therefore pushing on an open door. China was on the brink of deflation before US tariffs came along. The best way for China to combat deflation risk is to allow its currency - the Yuan - to fall against the Dollar. That has to come back on Beijing’s policy agenda.