China’s recovery may mean the Fed will have to hike rates longer

As the end of China’s stringent Covid restrictions quickens the country’s economic recovery, concerns about pent-up Chinese demand — and the inflation that may follow — could mean bad news for the U.S. Federal Reserve.

Economic data indicates that the Fed’s aggressive rate hikes are pulling down U.S. inflation, but China’s demand could make commodity prices return to levels from early 2022, before the U.S. central bank embarked on its journey of hiking rates to bring down inflationary pressures.

“In our view … a stronger China increases the chances of a stubbornly hawkish Fed,” Tavis McCourt, institutional equity strategist at Raymond James, said in his 2023 Outlook.

“With China, we do need more of everything – if that drives enough demand to get commodity prices back up closer to where they were in the spring of last year, then that puts the progress we’ve seen on inflation in a much more tenuous position,” he said.

With activity expected to pick up from China, demand for a variety of commodities will drive , McCourt said.

“As consumers are allowed out of their apartments, and start becoming more mobile, there’s going to be more gasoline demand and more jet fuel demand,” he said. “Demand is going to come back really quickly.”

Commodity prices have indeed seen significant gains since December, when China announced plans to lift some of its strictest Covid measures.

Three-month copper futures on the London Metal Exchange traded at $9,436 on Thursday morning – up around 12.5% month-to-date. Aluminum prices also rose 11.7% in January, FactSet Data showed.

In fact, Fed officials have voiced concern over China’s economy as a factor that could reverse its efforts to tame inflationary pressures in the U.S. economy.

St. Louis Fed President James Bullard said China’s reopening, paired with a lower chance of a recession in Europe, may cause inflation to reaccelerate.

“They’ve abandoned their Covid-zero policy and are moving toward reopening of China sooner than was previous expected, so that sounds like renewed upward pressure on the margin on global commodity markets,” Bullard said during a roundtable talk hosted by the Wall Street Journal on Wednesday.

“I’m nervous that will lead to upward pressure on inflation more generally – that’s a risk that we have to factor in when making in monetary policy,” he said. “Some of the factors that went in favor of the transitory story of 2022 may be reversing here,” he said.

China’s reopening may bring inflation worries, but the spillover effects onto the global economy could be limited, according to Morgan Stanley.

“As the recovery [in China] is driven more by consumption and not investment, we see limited spill-overs to inflation in the rest of the region,” the firm’s economists, led by Chief Asia Economist Chetan Ahya, said in a Wednesday report.

“Global goods demand/supply balances matter more, and with global goods demand still deflating, it will further limit any spillover effects to the region’s inflation,” they said.

One analyst said commodity prices may have “exploded” but questioned whether that would continue.

“Aluminum prices have exploded really in the past several months, on the same speculation … regarding China reopening,” Wolfe Research’s managing director Timna Tanners said on CNBC’s “Street Signs Asia.

“We definitely question whether or not it’s sustainable or supported by the data, but it is hard to fight some of this momentum into the reopening trade,” she said.

“We don’t necessarily think that there will be this huge spurt of activity in consumption or aluminum, but again, if the market thinks that, and inventories are low and there is some restocking before Chinese New Year, the momentum has really been powerful.”