Earlier optimism that China had turned the corner on deflation took a hit this week. Official data showed consumer prices rose just 0.5% year-on-year in July, down from June's 1% pace and marking the third consecutive month of deceleration. Even with energy costs climbing due to Strait of Hormuz disruptions, the slowdown was broad-based. Producer prices also lost momentum, rising 3.5% year-on-year versus 4.1% in June.
Yale economist Stephen Roach, who has long warned about China's deflationary trap, says the latest figures should temper any triumphalism. “However 2026 shakes out, hopes Xi's team is successfully deflating China's deflation could be in for a rude awakening,” he said. “Japan's example shows that even if headline data suggest that reflation is afoot, the deflationary mindset is very hard to change.”
Roach argues that deflationary pressures can persist long after headline inflation turns positive, quietly eroding confidence. That is why markets are buzzing about the possibility of People's Bank of China (PBOC) easing in the months ahead — a move that could weaken the yuan and widen China's trade surplus.
The surplus subtext
That surplus is the unspoken subtext, according to Brad Setser of the Council on Foreign Relations. “Of course, no one explicitly says they would welcome a bigger surplus,” he said. “But if an international institution's policy advice is monetary easing — to fight deflation — and fiscal consolidation because of off-balance-sheet risks, plus more exchange rate flexibility, it is effectively advocating for the country to export its way out of its domestic troubles.”
Yet Beijing has resisted letting the yuan slide. A stable or appreciating currency serves three strategic aims: reducing offshore default risk among heavily indebted property developers; supporting yuan internationalization, a long-term goal to elevate it as a reserve currency; and managing tensions with Washington, where the Trump administration remains highly sensitive to any hint of competitive devaluation. Right now, a firm yuan also helps China avoid importing even more inflation.
The harder problem, as Roach warns, is psychological — and Japan has spent decades proving how stubborn that psychology can be. Recent data reflect “stalling reflationary momentum,” notes Union Bancaire Privée economist Carlos Casanova. In the short run, he says, it's notable that the data show “weak domestic demand,” retail sales “remaining contractionary,” and “fading commodity cost pressures,” at least for now.
Casanova says that the PBOC itself has highlighted “growing structural divergence, with AI-related sectors outperforming even as broader consumption remains sluggish. Subdued credit demand also further limited monetary transmission.” That leaves scope for a 25 basis-point cut in the reverse repo ratio.
Setser is skeptical that currency policy is doing much of the work either way: “There's no evidence that the nominal depreciation of 2022-2023 materially reduced the pace of deflation in China, and also zero evidence that the modest nominal appreciation of the last year led to a faster pace of deflation. If anything, the pace of deflation has moderated, though I fully accept that higher oil prices have had something to do with that.”
Still, many fear the PBOC is behind the curve. Société Générale economist Michelle Lam notes that “China's growth likely cooled notably in the second quarter to 4.4% as weak consumption and property activity outweighed resilient exports and a modest quarter-end industrial rebound.” She adds that “while producer-led reflation supported nominal growth, policy easing is likely to remain incremental rather than a precursor to large-scale stimulus.”
The bigger question is just how incremental. Japan's long struggle shows how stubborn deflationary psychology can be to defeat: though Japanese consumer and producer prices are rising, households still lack the confidence to increase spending enough to hasten economic growth or lift business confidence over the long run.
For Chinese President Xi Jinping, the most urgent reforms are resolving a chronic housing crisis that increasingly resembles Japan's 1990s bad-loan spiral, and building a real social safety net so 1.4 billion citizens feel confident enough to spend rather than hoard savings. These priorities are tightly linked — with roughly 70% of household wealth tied to property, stabilizing the real estate market across China's 70 biggest cities is essential to reviving consumption and sustaining 4.5%-5% economic growth.
The longer Xi's government lets these pressures fester without decisive action, the more a deflationary mindset takes hold — and the harder it becomes to shake. Japan remains the cautionary tale. Even as the Bank of Japan struggles to lift short-term rates above the current 1% level — the farthest from zero in more than three decades — deflationary undercurrents still run through the economy, particularly in wages, which continue to lag inflation. The result has been a slow-burn form of stagflation, and Tokyo has yet to deliver the structural reforms needed to close the gap between rising prices and stagnant household incomes.
Toshihiro Nagahama, economist at the Dai-ichi Life Research Institute, argues that for Japan “to fully break free from its long-standing deflationary mindset, it's imperative for the government and the central bank to align, articulate their risk assessments, maintain honest and transparent dialogue with financial markets, and resolutely execute bold, long-term growth investments.” Nagahama speaks for many when he argues that today's global economy is being reshaped before investors' eyes by wars in Ukraine and the Middle East, alongside a series of historic turning points in central bank policies amid rising global inflation and a strong dollar.
Amid so much uncertainty, governments can't anchor their strategies to hopeful scenarios — they must instead plan around worst-case risks, including the possibility of a multi-year disruption in the Strait of Hormuz, a chokepoint that could send energy prices soaring and complicate the inflation picture further. For China, the path out of deflation is not just about tweaking interest rates; it requires a fundamental shift in household confidence and a decisive break from the property-led growth model. As China's bamboo growth model shows, flexibility and resilience are key, but without addressing the root causes, the deflationary mindset may prove as stubborn as Japan's.
