Signs of deflation are becoming more prevalent across China, heaping extra pressure on Beijing to reignite growth or risk falling into an economic trap it could find hard to escape.

While the rest of the world tussles with inflation, China is at risk of experiencing a prolonged spell of falling prices that—if it takes root—could eat into corporate profits, sap consumer spending and push more people out of work. Its effects would ripple across the globe, easing prices for some products that countries like the U.S. buy from China, but would also deprive the world of important Chinese demand for raw materials and consumer goods, while also creating other problems.

Prices charged by Chinese factories that make products ranging from steel to cement to chemicals have been falling for months. Consumer prices, meanwhile, have gone flat, with prices for certain goods—including sugar, eggs, clothes and household appliances—now falling on a month-over-month basis amid weak demand.

Most economists think China will probably avoid a deep and lasting period of deflation. Its economy is growing, albeit sluggishly, and the government has unveiled a variety of small stimulus measures that could help more. Earlier in July, Liu Guoqiang, a Chinese central bank official, dismissed concerns that China is slipping toward deflation.

But some economists see alarming parallels between China’s current predicament and the experience of Japan, which struggled for years with deflation and stagnant growth.

In the 1990s, a collapse in stock markets and real-estate values in Japan pushed companies and households to drastically cut back spending to service burdensome debts—a so-called balance-sheet recession that some see taking shape in China today.

Data released Thursday showed industrial profits are sinking and average new home sale prices fell in June.

If China were to tip into protracted deflation, it has another big problem: Traditional methods of fighting it are either unpopular in Beijing, or lack potency due to the country’s heavy debt load and other issues. Beijing is wary of large deficit-financed spending programs that could juice growth and push prices higher, while big debts mean consumers and businesses are reluctant to borrow and spend.

“The big concern is whether the policy tools that they have will have much traction in terms of trying to avert deflation, or deal with deflationary pressures once they arrive,” said Eswar Prasad, a professor of trade policy and economics at Cornell University and a former head of the International Monetary Fund’s China division.

For the global economy, extended deflation in China might help cool inflation elsewhere, including the U.S., since its factories make up such a large share of the world’s goods.

However, a flood of cut-price Chinese exports on global markets could squeeze out rival exporters in some countries, hurting jobs and investment in those economies. Chinese export prices for steel and chemicals fell by about a third over the 12 months through June.

A deflationary spell in China would also likely mean weaker Chinese demand for food, energy and raw materials, which big chunks of the world rely on for export earnings.

“The market is underestimating the deflationary impact on the global economy,” said Frederic Neumann, chief Asia economist at HSBC in Hong Kong.

Consumer prices in the U.S. rose 3% in June from a year earlier, a sharp slowdown from the 8% annual rate a year earlier but still above the 2% rate targeted by the Federal Reserve. Annual inflation in the European Union last month was 6.4% as the region continues to feel the squeeze from high energy and food prices.

In China, annual consumer-price inflation in June was zero. Producer prices fell in China last month by 5.4% from a year earlier.

Subdued consumer spending is one big reason. Some idiosyncratic factors are also at play, including a steep rise last year in the price of pork—a staple in the Chinese diet—that hasn’t been repeated.

But weak price pressures are also a payback of sorts for China’s experience during the Covid-19 pandemic, when exports rocketed thanks to Western demand for gym equipment, home improvement supplies and other goods.

The demand surge helped push Chinese producer prices up 12% between the start of 2020 and their peak in April last year, according to an index calculated by Moody’s Analytics.

When governments lifted lockdowns and Western demand eased, the trend reversed. Producer prices began falling on a year-over-year basis in October and have kept falling every month since.

Chinese factories, which expanded to meet Western demand during the pandemic, now face overcapacity. The hope was that Chinese consumers would step into the breach and soak up excess inventories as export markets dried up. But that hasn’t happened, and as more businesses pivot toward selling into the domestic market, the downward pressure on prices is building.

With global energy and food prices also weaker than before, economists expect overall consumer prices in China to stay nearly flat, or even fall, in the coming months. In addition to many foodstuffs and clothing items, prices have also been falling for electric vehicles, as Chinese automakers and Tesla have slashed prices amid slower sales growth and in an effort to win more share in a crowded market.

China could escape further deflation if growth regains momentum later this year, helped by government stimulus, as some economists anticipate. Nomura economists expect annual consumer-price inflation in China of negative 0.2% in the third quarter, with inflation eventually turning positive again toward the end of the year.

The risk for China is that deflation proves more persistent than expected. Falling prices tend to squeeze spending as consumers await a better deal tomorrow, reinforcing a downward spiral.

The longer it lasts, the more severe its effects become. Entrenched deflation means debts become harder to bear as profits and incomes fall. Companies shed workers to fatten shrinking margins.

In Shanghai, Liu Wang has held off on plans to upgrade his apartment because he is worried about sinking more money into a property whose value he believes could keep dropping.

“The economic condition is highly uncertain now,” said Liu, who works at a logistics firm that is shifting its focus toward domestic business after its export business weakened. In his hometown of Qufu in China’s northeastern Shandong province, demand for homes has been tepid despite a drop in prices, he said.

“The housing bubble is still quite large,” Liu added. “I don’t see any reason why prices will go up.”

In Japan, deflation first appeared in 1995. Excluding a few respites, it more or less stuck around until the 2008-09 financial crisis. Even today, Japan is battling to sustain higher rates of price growth with ultraloose central bank policies.

One textbook response is a massive monetary expansion, lowering interest rates and printing money to spur borrowing and spending, which in theory should trigger more inflation.

But data show Chinese companies are reluctant to take on new debt to expand production, while droves of homeowners are choosing to repay mortgages early. Both are signs of weak demand for loans, muffling the effectiveness of interest-rate cuts.

A major reason is that many companies and households already have such large debts that they don’t want to add more. Household debt has surged to 1.5 times that of income, far above the level of most developed countries, including the U.S., according to calculations by Jens Presthus, associate director of Global Counsel, an advisory firm.

Deflation, or even just the fear of deflation, can make the problem worse. Borrowers worry the cost of servicing their debts is going to rise, so they respond by saving more and spending less.

“Deflation is particularly dangerous when there’s a lot of debt,” said Arthur Budaghyan, chief emerging markets economist at BCA Research.

If you still don’t have your office groove back, there might be a scientific explanation. Hybrid work arrangements mess with our brains.

Frustrated bosses who survey their half-empty officescapes say it makes no sense that somebody who worked full time in an office before 2020 can’t show up like they used to. But neurologists and behavioural scientists say the collective amnesia for effectively working alongside each other makes perfect sense to them.

Some workers have lost the muscle memory in their minds required to get jobs done in an open-office setting and, like flabby biceps, that muscle has to be exercised to strengthen, says S. Thomas Carmichael, professor and chair of the neurology department at UCLA’s David Geffen School of Medicine.

After years of remote work, our brains’ selective attention skills and ability to block out distractions is weakened, Carmichael says. Those who prefer to work from home might not like one of his remedies: Make yourself work from the office more often.

“The brain is really good at understanding contingencies, so if we just say ‘I’ll just get this done when I’m at home,’ we don’t learn it as well,” he says.

Drowning in a sea of ‘what ifs?’

Knowing how effective working from home can be has created a simmering unhappiness, says organisational psychologist Cathleen Swody. Many workers lose their uninterrupted autonomy in social office spaces.

Maryia Babinova, a senior software engineer in New York City, tried going into her office several days a week back in 2021 and found it nearly impossible to be productive.

“The first 30 to 45 minutes of my day were taken up by saying hello to everybody,” she says.

Babinova says even small office time wasters have become a major annoyance. A trip to the office coffee machine, for instance, can take as long as 15 minutes when there’s a line. At home, she says, caffeine is at her fingertips, keeping her on task.

Now, Babinova only shows up in person when her team members visit from another city. At the office, she works on tasks that don’t require a heavy mental lift so she can get them done.

Constantly comparing 2023’s office realities with alternative remote-work setups can add to workers’ readjustment woes, says Laura M. Giurge, an assistant professor at the London School of Economics, who teaches a course on the science of time at work.

When people start to ponder what life would be like if their circumstances were different, they can rapidly end up drowning in a sea of “what ifs,” a psychological concept known as counterfactual thinking.

“Now, when we go to the office, we have the counterfactuals of our home offices,” Giurge says. “We know how much better things would be…how much more work we might get done.”

It’s hard to un-remember how nice it was to take the dog for a walk midday, or how helpful it was to log out at 4 p.m. to get dinner started and log back in later. Running through scenarios of how time could be better spent takes up precious brainpower, distracting us from the real work at hand, psychologists say.

Unsettling quiet

Getting used to working with background noise takes time.

Many workplaces are quieter now because they are less crowded, and that means there can be periods of dead silence punctuated by sudden noise that feels magnified, jarring people again and again all day long. Even toggling between work-from-home solitude one day to a noisy office the next can have a similar effect.

“We have to habituate ourselves to all those distractions all over again in order to get any good work done,” says Vanessa Bohns, a professor of organisational behaviour at Cornell University. She points to research that shows it takes 20 minutes to get used to background noise, but five minutes of silence before bringing back the noise forces the brain’s process to start over again.

Many workers and a few bosses now view the office as a place to collaborate, but not the only place to do head-down individual work.

In a large-scale survey published by Microsoft last year, 84% of employees cited connecting with co-workers as their key motivation for working in person. More than 70% said they would go to the office more frequently if they knew their direct team members or work friends would be there.

“The data shows we can’t only see the office as a place to get focused work done,” said Colette Stallbaumer, Microsoft’s general manager of Future of Work.

Lynn Dang, a software developer in the Dallas area, uses her three mandatory office days for face-to-face meetings and work that doesn’t require intense concentration.

When she transitioned back to the office last year, she noticed she couldn’t concentrate on reading code like she could while working from home. Loud team discussions and overhearing one-sided conversations amid the cubicles from people who were on the phone or dialled into video meetings created a constant assault on her senses.

“It was like I’m gonna have to find something to do on my to-do list that would make me productive,” she says. “Otherwise I’m going to have to keep working overtime or working over the weekend just to get stuff done.”

Recent good news on inflation has ignited a debate over how much central banks’ interest-rate increases are responsible.

The answer matters for where inflation and interest rates are headed. The Federal Reserve and the European Central Bank in the past week lifted their benchmark interest rates to 22-year highs and left the door open to additional increases.

If higher rates weren’t responsible for the progress on inflation to date, that suggests central banks may be able to lower them before a painful recession sets in.

Central banks generally see their influence on inflation coming through higher rates damping the demand for goods, services and workers, which leads to higher unemployment. That in turn puts downward pressure on prices and wages.

Only the second part of that sequence has occurred. Inflation fell to 3% in the U.S. in June, according to the Fed’s preferred gauge, the personal-consumption expenditures price index, down from 7% one year earlier. Yet the unemployment rate, at 3.6% in June, has held steady for the past year.

In the eurozone, inflation declined to 5.5% in June, the lowest level in nearly 18 months, and unemployment has drifted to the lowest in more than 25 years.

There are competing explanations for this.

One camp argues that inflation has been mostly driven by supply shocks that are going away on their own—much as a postwar surge in the late 1940s unwound by itself. The ripple effects gave the illusion of broader, more persistent price increases.

Take the auto market. Sellers weren’t able to meet pent-up demand two years ago, leading to huge price increases, which in turn spawned higher prices later on for car repairs and auto insurance.

Similarly, a surge in household formation during the pandemic sent up housing prices and rents.

The first camp attributes most of the recent decline in inflation to the ebbing of these one-time supply disruptions, not rate increases, which are supposed to work through the labor market. “It’s calling into question a lot of the old assumptions,” said Lindsay Owens, executive director at the Groundwork Collaborative, a liberal think tank.

A second camp, which includes most economists, disagrees. They say monetary policy kept demand for goods, services, and labor lower than otherwise, taking pressure off strained supply chains and allowing price pressures to ease.

Interest rates can also influence behaviour. The prospect that central bankers would risk a recession to bring down inflation may have influenced expectations of price- and wage-setters, including corporate executives who plan annual budgets for investment and hiring.

Jamie Dimon, chief executive of JPMorgan Chase, warned one year ago of an economic “hurricane” as central banks accelerated rate increases. “You’d better brace yourself,” he said in June 2022, and pledged the bank would be “very conservative” with its balance sheet.

“Inflation is coming down precisely because the Fed avoided more excess demand growth, and they anchored inflation expectations,” said Angel Ubide, head of economic research for global fixed income at Citadel, a hedge-fund firm.

Inflation would be higher now if not for Fed rate increases, “and maybe still rising,” said Karen Dynan, an economist at Harvard University.

In 2021, supply-chain constraints meant even marginal increases in demand led to unusually large price increases. The reverse might be true now: Marginal decreases in demand can bring down prices faster, particularly if more supply is becoming available.

The car market illustrates how monetary policy has been transmitted. Rising rates raised monthly payments, damping demand and robbing sellers of pricing power. In addition, since March, banks appear to be rejecting more car-loan applications.

“That’s leading to a new group of people getting squeezed out of the market, and therefore, it’s playing a role putting downward pressure on prices,” said Julia Coronado, founder of economic-advisory firm MacroPolicy Perspectives.

In Europe, economic growth has stalled since late last year. Business surveys in the past week suggest that growth is weakening sharply, especially in manufacturing, which is most sensitive to interest rates.

The net share of banks reporting increased loan demand declined to a record low in the three months through June, according to an ECB survey of banks. Credit growth to households is the lowest since mid-2016.

Asked at a news conference on Thursday about the transmission of ECB rate increases to growth and inflation, President Christine Lagarde said that in the financial system, “a lot has been transmitted. A lot. We know that. In the economy at large, not as much yet.”

A report published by German insurer Allianz identifies three different forces on the U.S. inflation rate since the second quarter of 2022. Higher inflationary pressures from consumption growth, strong labor markets and government spending added 4 percentage points; fading supply-chain disruptions subtracted five points, and Federal Reserve actions subtracted another five. The net impact was that inflation fell 6 percentage points, whereas it would have fallen only one point without the Fed’s actions.

Fed Chair Jerome Powell said rate increases are “working about as we expect, and we think it’ll play an important role going forward” in bringing down prices for the most labor-intensive services.

Monetary policy has also affected the labor market, but this has shown up in declining job-vacancy rates rather than rising unemployment, some economists say.

Hiring plans in the eurozone services sector are dropping rapidly, according to a survey this month by the European Commission, the European Union’s executive body.

“The labor market is normalising on both sides of the Atlantic, reflecting the impact of higher rates,” said Stefan Gerlach, a former deputy governor of Ireland’s central bank.

The debate over the effect of rate increases also matters for how much further, if at all, central banks need to lift them. Optimists underestimated how much strong demand lifted inflation two years ago. Pessimists may be overestimating the importance of constraining demand to bring it down now.

Gerlach expects inflation to continue declining as higher rates sap demand. “I’m worried central banks have done too much,” he said. “They may have felt embarrassed about having misunderstood inflation the first time.”