SLOWING CHINA COULD GIVE FED THE CHILLS / THE WALL STREET JOURNAL

Heard on the Street

Slowing China Could Give Fed the Chills

By Justin Lahart

Oct. 10, 2014 3:44 p.m. ET


The slowing of China’s economy is exerting significant downward pressure on prices in the U.S. There may be much more to come.

With recent economic data even weaker than expected, there has lately been a reassessment of how quickly China is likely to grow. Last week, the World Bank lowered its forecast for Chinese gross domestic product growth in 2014 to 7.4% from 7.6%, and in 2015 to 7.2% from 7.5%. Many private forecasts are lower.

Slower Chinese growth could presage a cooling in prices that could give the Federal Reserve the fits. Its preferred measure of inflation is already below its 2% target, raising the risk of deflation if a recession should hit, as well offering a signal that plenty of slack remains in the economy.

China’s slowdown is an important reason commodity prices have fallen so much in recent months. China-made raw materials, like aluminum, that until recently were taken up by domestic demand are now getting exported, pushing prices down globally. Years of rising Chinese energy demand led to the development of new sources of oil, like shale production, and drove the developed world to improve its fuel economy. But now that China’s economy has decelerated, there’s a threat of a glut, and oil prices have fallen sharply.

The drop in oil prices, in particular, will cool consumer inflation in the months ahead as it shows up at the gasoline pump. And as it moderates manufacturing and freight costs, it will over time damp price increases for other goods as well.

The more persistent effect of China’s slowdown on inflation, however, could come through the prices of the Chinese goods the U.S. imports. These have lately shown hints of slippage: The Labor Department reported Friday that its index of Chinese import prices was down 0.1% in September from October, which put it 0.1% above its year-earlier level. If China moves to ramp up exports in a bid to keep the economy from slowing too quickly, U.S. import prices could get a lot softer.

China has targeted GDP growth of about 7.5%, and its leadership will tolerate it growing a bit slower next year. Unwilling to court unrest, it will be at pains to ensure growth doesn’t fall too quickly. With low Chinese inflation readings suggesting consumer demand is still too weak to drive the economy on its own, China may turn to exports to keep the economy purring. But export-fueled growth won't be as easy to pull off as in the past.

In the 2000s, China massively increased its export position. Its share of U.S. manufactured-good, machinery and transportation-equipment imports went from 10.4% in 1999 to 29.2% in 2009. But then its import-penetration stalled, with its share of those imports coming to 28.8% last year.

One reason is the financial crisis. As well, events like 2011’s earthquake and tsunami in Japan and floods in Thailand prompted many companies to rethink the logic of long supply chains. Another reason is that rising wages cut into the labor-cost savings China could offer. A further one is that in categories ranging from pantsuits to personal computers, Chinese imports were close to the saturation point, with remaining categories much harder to crack.

That doesn’t mean China’s share of imports in the U.S. and other countries can’t grow. But it may mean that it will have to charge lower prices to do it. The date when the Fed finally meets its 2% inflation target is looking even further off.