For US inflation, China’s slowdown is a double-edged sword

The eyes of global investors are on the Fed and US inflation. To understand how this will evolve, they should pay more attention to the world’s second largest economy.

China’s impact on the US inflation picture will be deeper than many imagine, but it also works through two different channels. Which ultimately dominates will be a big factor in inflation later this year, and how aggressively the Fed will ultimately have to act to contain it.

The first channel is harder in the global supply chain. Strict measures to contain the Omicron variant at the world’s largest manufacturer have thrown a wrench into global production and logistics networks. Many cities, including Shanghai, have been in lockdown for weeks. Factories were closed and ports congested. Chinese industrial production fell 2.9% year-on-year in April, while dollar export growth slowed to 3.9%, the slowest pace in nearly two years.

Things could improve in the short term as Shanghai – a major port and business hub – plans to gradually reopen, but China’s zero-tolerance approach to Covid-19 doesn’t seem to be going away. There may be intermittent shutdowns across the country and business disruptions for some time, which could drive up prices for manufactured goods globally through this year and into 2023.

Slower exports from China and reduced port congestion on the US West Coast have recently led to lower freight rates. But the container backlog at the port of Shanghai, as Chinese exports rebound to make up for lost time, will likely spill over to the west coast over the summer months as well, according to Fitch Ratings.

A saving grace is that as the U.S. economy continues to open up, consumption has shifted back to services from goods, which could help ease the strain on Chinese and global production and logistics networks.

Despite censorship, videos shared online show growing desperation and anger over prolonged Covid-19 lockdowns in China’s economic capital of Shanghai, where officials are trying to address issues such as food shortages while doubling down on politics the country’s strict pandemic policy. Photo composition: Emily Siu

To make matters even more complicated, however, China’s zero Covid policy is also having a distinct, moderating effect on global inflation: slowing growth in the world’s largest consumer of most key industrial goods is putting a damper on rising material prices. Prices for industrial metals like iron ore and copper have fallen over the past month, especially since China’s property market remains sluggish due to headwinds from Omicron.

Perhaps most importantly from a U.S. perspective, the Chinese lockdowns and slowing industrial activity also mean lower demand from the world’s biggest oil importer. Despite a rebound in April, China’s year-to-date crude imports fell 4.9% from the same period in 2021. The U.S. Energy Information Administration and the The International Energy Agency both cited falling consumption in China when they downgraded their 2022 oil demand forecasts this month.

For U.S. consumers hit by both high gasoline and consumer goods prices, a sharp downturn in China’s manufacturing juggernaut is both upside and downside.

Write to Jacky Wong at jacky.wong@wsj.com

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