Inflation's Second Act

The Great Inflation Divergence

The most striking feature of the 2026 inflation landscape is the degree of divergence between major economies. In January 2026, US headline CPI stood at 2.4% year-over-year, with core CPI at 2.5% — the lowest core reading since April 2021 but still above the Federal Reserve's 2% target. The Eurozone recorded 1.9% in February 2026, essentially at the European Central Bank's target. Japan recorded 1.5% in January 2026, down from 2.1% the prior month. And China recorded just 0.2%, sharply below the 0.8% recorded in December 2025 and well below consensus expectations of 0.4%.

This divergence reflects fundamentally different economic structures and policy choices. The United States is experiencing cost-push inflation driven by tariffs and supply chain restructuring layered on top of a tight labour market where nominal wages grew 4.3% in the year to January 2026, outpacing inflation by 1.9 percentage points. The Eurozone has benefited from weaker energy prices and more subdued demand. Japan is experiencing a structural shift away from its decades-long deflationary equilibrium, with the Bank of Japan raising rates to 0.75% — the highest since 1995 — and 30-year Japanese government bond yields reaching record highs above 3.4%.

China's near-zero inflation reflects a fundamentally different economic dynamic: massive overcapacity in manufacturing sectors combined with a property market downturn that has destroyed household wealth and suppressed consumer spending. Full-year 2025 CPI averaged exactly 0.0%, technically avoiding deflation by the narrowest possible margin.

Overcapacity and the Property Drag

China's deflation challenge is not cyclical — it is structural, rooted in overcapacity across strategic manufacturing sectors and the ongoing deflation of the property market. Producer prices have been in negative territory for over 40 consecutive months, with the PPI recording -1.9% in December 2025. This is the longest sustained period of producer price deflation since China began reporting the measure.

The overcapacity is concentrated in sectors that China has designated as strategic priorities under its industrial policy. Lithium-ion battery production capacity exceeded 3 terawatt-hours in 2024, approximately three times total global demand of around 1 terawatt-hour, with planned capacity of over 6 terawatt-hours sufficient to meet global needs until 2035. Polysilicon prices for solar panels fell to less than one-fifth of their 2022 peak. Steel rebar prices hit eight-year lows in May 2025. Electric vehicle manufacturers are engaged in what Chinese commentators term 'involution' — destructive price competition that compresses margins across the entire supply chain.

The property sector compounds the deflationary pressure. Real estate sales fell 12.6% in 2025 to 8.4 trillion yuan — less than half the 18.2 trillion yuan peak reached in 2021. Secondary market prices declined 6.1% year-over-year in December 2025. Since residential property represents approximately 70% of urban household wealth in China, falling prices create a powerful negative wealth effect that suppresses consumption and reinforces deflationary psychology.

When Trade Policy Becomes Monetary Policy

The United States' escalating tariff regime has introduced a new structural inflation driver that operates independently of traditional demand-supply dynamics. According to the Yale Budget Lab, tariffs had added approximately 0.7 percentage points to US CPI by September 2025. Without the tariff impact, US inflation would have been approximately 2.2% — essentially at the Fed's target — rather than the 3.0% recorded at that time.

The tariff impact has been most acute in electronics, where computer prices rose 3.1% between December 2025 and January 2026 alone, and in apparel, where effective tariff rates on Chinese textiles spiked from 13% to 54% during the spring 2025 escalation before easing to approximately 36% by February 2026 — still well above the historical norm of approximately 15%.

The pass-through dynamics are evolving in ways that have significant implications for the inflation outlook. Currently, approximately 80% of tariff costs are being absorbed by importers and retailers rather than passed through to consumers. But this absorption is unsustainable — it depends on pre-tariff inventory stockpiles that are now depleting. As companies work through their advance purchases, the pass-through rate is expected to increase, with the Yale Budget Lab estimating an additional 50 basis points of tariff-driven inflation by mid-2026.

The Widest Gap in Decades

The divergence in inflation dynamics has produced an equally dramatic divergence in monetary policy. The Federal Reserve holds its policy rate at 3.5-3.75%, with the median FOMC projection suggesting only one 25 basis-point cut in 2026. The European Central Bank has paused, with no cuts expected through the year. The Bank of England is expected to deliver two cuts. The PBoC has held its loan prime rates at 3.0% (one-year) and 3.5% (five-year) for seven consecutive meetings, maintaining room to cut further as deflation persists.

The most consequential shift is at the Bank of Japan. After decades of ultra-loose policy — including yield curve control from 2016 to mid-2025 and negative interest rates — the BoJ has pivoted to a hiking cycle, raising rates to 0.75% in December 2025. Market expectations point toward 1.5% by end-2026. The practical implication is that the BoJ's shift functions as a de facto increase in the global risk-free rate, even if the Fed cuts — because Japanese capital that was previously deployed globally in search of yield is now being attracted back to domestic markets.

For Chinese companies, the policy divergence creates several practical challenges. Dollar-denominated borrowing costs remain elevated relative to renminbi costs, creating a spread that penalises companies with significant offshore dollar liabilities. The interest rate differential also contributes to currency pressure on the renminbi, complicating hedging strategies for companies with multi-currency revenue streams.

Why Inflation Will Not Return to Pre-Pandemic Norms

Beyond cyclical forces and tariff effects, several structural drivers are embedding a permanently higher inflation floor in the global economy. These forces operated in reverse during the 2000-2020 period — when globalisation, Chinese manufacturing integration, technological deflation, and low energy costs combined to suppress prices. Each of these tailwinds has either stalled or reversed.

Deglobalisation and reshoring costs

Approximately 40% of US companies plan to relocate at least part of their supply chains to North America by 2026, according to Deloitte. This reshoring creates direct cost inflation — US and Mexican labour costs are significantly higher than Chinese equivalents, and new facilities require years of capital investment before reaching efficient scale. Global shipping costs rose approximately 12% in 2025, adding further cost pressure.

Energy transition costs (greenflation)

The energy transition is inherently inflationary in the medium term. A $5 per tonne increase in carbon pricing leads to approximately 0.7% price level increase within one year, according to academic research. Critical minerals required for the transition — lithium, cobalt, nickel, rare earths — face supply concentration risks, with the top three producing regions controlling 86% of the market for key battery minerals, up from 82% in 2020. Approximately 21% of Belt and Road energy engagement in 2025 targeted renewables, with clean energy investments hitting a record $9.7 billion in H1 2025, embedding greenflation costs into infrastructure investment.

Strategic Implications for Chinese Enterprises

The new inflation regime requires Chinese companies to rethink assumptions that have held for two decades. The era of low global inflation that coincided with — and was partly caused by — China's integration into global manufacturing is ending. Companies must now navigate a world where inflation is simultaneously too high in their export markets and too low in their home market.

• Input cost management: Companies should scenario-plan for sustained producer price deflation at home (compressing margins on domestic sales) alongside rising input costs for international operations (shipping, energy transition materials, compliance costs)

• Pricing strategy: In markets with tariff exposure, companies should evaluate renminbi invoicing, local currency settlement, and value-added positioning that supports pricing power above commodity-level competition

• Treasury management: The interest rate differential between Chinese and Western rates creates opportunities for arbitrage but also risks for companies with mismatched currency exposure. The BoJ's rate normalisation adds a new variable to multi-currency treasury strategies

The End of 'One Inflation'

The post-pandemic inflation experience has revealed that the low, stable, globally synchronised inflation of the 2010s was not a natural equilibrium but the product of specific structural conditions — open trade, cheap Chinese manufacturing, low energy costs, and restrained fiscal policy — that have all partially or fully reversed.

The new regime is characterised by persistent divergence, structural floors, and policy uncertainty. For Chinese companies, this means the inflation landscape is no longer a background variable that can be safely ignored — it is a foreground strategic factor that affects pricing, financing, currency management, and competitive positioning in every market they operate in.

Inflation's second act is not a sequel — it is a different genre entirely. The companies that recognise the structural shift and adapt their operating models accordingly will outperform those that wait for a return to the pre-pandemic norm.

This article is for informational purposes only and does not constitute financial, legal, or investment advice. Data sourced from BLS, Eurostat, ONS, BoJ, NBS, Federal Reserve, ECB, PBoC, CBO, Yale Budget Lab, World Gold Council, OECD, IEA, and other cited sources.