China is edging toward deflation. Here's what that means.

Whereas the U.S. continues to grapple with elevated prices, China is dealing with the opposite problem. In July, the world's second largest economy slipped into deflationary territory, with consumer prices declining 0.3% from a year earlier. 

The decline in consumer prices sets China apart in more ways than one. In the post-COVID era, many nations, ranging from the U.K. to the U.S., have struggled with high inflation sparked by a combination of government spending and tight labor markets, which have sent their economies into overdrive. 

China's deflation comes amid high unemployment for its younger workers, with more than 1 in 5 people between 16 to 24 unable to find a job. Meanwhile, the country's economic activity fizzled out earlier than expected following the lifting of virus controls, prompting Chinese leaders to try to shore up business and consumer activity. 

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"China's economic trajectory has been a focal point of global attention for decades, with its staggering growth and transformation capturing the world's imagination," noted Nigel Green of wealth management company deVere Group in a Wednesday research note. "But the recent emergence of serious deflationary pressures in the world's second-largest economy is triggering concerns that extend well beyond its borders."

Here's what to know about deflation. 

What is deflation? 

Deflation is a decline in overall price levels, and is the opposite of inflation, when prices rise over a period of time. 

Deflation typically is linked with economic downturns, such as during the Great Depression in the U.S. during the 1930s, according to the Federal Reserve Bank of San Francisco. 

Is deflation bad?

Deflation might seem like a good trend, at least on the face of it — after all, if prices decline, that means your paycheck will go farther because and, in theory at least, you'll have more purchasing power. 

But deflation's impact can hit a nation's broader economy in a number of negative ways. For one, if people believe items will cost less next week or next month, they may hold off on buying products or services, strangling the lifeblood of an economy: consumer spending.

If that happens, companies could respond by cutting workers, trimming wages or making other adjustments.

Secondly, deflation is a negative for people or businesses with debt, such as mortgages or other loans. That's because even though prices are falling, the value of debt doesn't change, which puts pressure on consumers and businesses to cut spending in order to service their debt payments. 

Why is China experiencing deflation? 

China's deflation appears to be coming from two sectors — transportation and food, with pork prices down 26% year over year, Ben Emons, senior portfolio manager and head of fixed income at NewEdge Wealth, said in a Wednesday research note. 

Stripping out volatile food and energy prices, China's consumer price index rose 0.8% in July, he noted. Overall, the deflation experienced last month in China is "mild" and could be quickly reversed, Emons added.

"China may be in deflation but that is less likely to persist as the Chinese government is set on hitting the GDP target of 5.5%," he wrote. "Moreover, pork-driven disinflation can be manipulated, which means that China CPI deflation is likely to reverse quickly."

Could deflation in China impact the U.S.?

It's possible, partly because the U.S. imports a lot of goods from China, according to economists and market experts. 

"As its exports become cheaper due to deflation, other economies might face increased competition, forcing them to lower their own prices or risk losing market share," Green of deVere group noted.

He added, "Also, reduced demand for raw materials and commodities due to its economic slowdown is likely to lead to a decrease in global commodity prices."

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