Consumer inflation in the year to date has turned negative through January-February for the first time since 2021. While an earlier-than-usual Lunar New Year holiday helped push price growth below zero last month, the downswing was far sharper than predicted, suggesting inflation was feeble even when adjusted for seasonality.

For global banks like Citigroup Inc. and Nomura Holdings Inc., the worry is that consumer prices could hover near contraction territory for the rest of the year if robust production overwhelms demand at home. As the People’s Bank of China prioritizes yuan stability over monetary easing in the near term, dragging the country out of deflation will likely hinge on the ability of policymakers to tackle overcapacity.

The latest CPI reading “is a pretty good illustration that this deflationary environment is a permanent rather than transitory phenomenon,” said Dan Wang, China director at Eurasia Group. “Overcapacity, plus a relatively conservative monetary stance, would actually prolong this deflation pressure rather than alleviating it.”

Consumer inflation could rebound but only reach near zero in March, according to estimates by Citigroup and Nomura. The consensus forecast for the full year among analysts surveyed by Bloomberg is a 0.7% gain.

Economist estimates for Chinese inflation have consistently overshot the actual readings for the past two years. 

The deflationary pressures coursing through the economy showed signs of spreading in February, with a drop in services prices and declining costs of consumer durable goods. China’s core CPI, which excludes volatile items such as food and energy, decreased for the first time since 2021.

Since achieving a sustained revival of consumer confidence could take months, and will depend in large part on whether the property market bottoms out, China’s potential supply-side reform would be key to easing factory deflation, Citigroup economists including Xinyu Ji wrote in a report Sunday.

Key officials who spoke last week on the sidelines of the annual legislative session already hinted at plans to push for “inefficient capacity” to exit the market. 

The government also gave a more realistic assessment of deflationary pressures in this year’s annual work report and budget than before. The Ministry of Finance is projecting nominal economic growth at around 5% in 2025—matching Beijing’s inflation-adjusted target and implying that overall price gains are estimated at around zero.

China has seen economy-wide prices falling for two straight years. That deflation streak is likely to extend to 2025 to become the longest since the 1960s. 

Declining prices have weighed on corporate profits, workers’ wages and fiscal income. Over time, entrenched deflation could lead to reduced investment and consumption. 

“Insufficient domestic demand and the level of prices will continue to weigh down government revenues,” the Ministry of Finance said in the budget report, adding that lower-than-expected producer prices resulted in a decline in value-added tax revenue last year.

Other officials also expressed a greater awareness of deflation risks. 

Chen Changsheng, a member of the team that drafted the government work report, said during a press briefing last week that China’s “consistently low prices are not good.” The threat is that could lead to higher real interest rates and a heavier debt burden, which would result in fewer jobs and might make businesses more reluctant to invest, he said. 

Despite a wider recognition of the issue by the highest echelons of power in China, policymakers have yet to make addressing deflation a top priority in the face of threats from U.S. tariffs, according to economists. 

“Preventing shocks of domestic and external origin is a more important consideration for monetary policy,” Guotai Junan Securities Co. analysts wrote in a report Sunday. Monetary policy has become “temporarily insensitive” to inflation data, they said. 

Eurasia’s Wang said China’s priority, for now, is to “fend off the threat from the U.S.”   

“That’s why doubling down on investment in technology and the heavy industry is more key than tackling domestic deflationary pressure,” she said.