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What Drives Inflation in Asia and Why it Matters

Of all the things policymakers have had to worry about in the past couple of years, inflation wasn’t one of them. Some even heralded the end of inflation.

Today, inflation still isn’t a ‘problem’ in Asia. For the most part, it remains relatively modest, but it is on the rise in some countries in the region. And understanding what is driving that inflation matters. Policymakers need to consider the sources of inflation in making the right policy choices. What policy tools to choose. And, at this juncture, how to manage the withdrawal of policy stimulus left over from the crisis, and strike the delicate balance between low inflation and economic growth.

The issue of what drives inflation—or so-called inflation dynamics—is one of the issues we examined in our October 2010 Regional Economic Outlook for the Asia and Pacific region. In this post, I wanted to share with you a few of our findings.

Inflation pressures are building up

Although inflation has generally remained within what central banks consider to be a comfortable zone, the conditions are ripe for rising core inflationary pressures—that is, inflation excluding volatile items such as food and energy.

For a start, economic activity in much of emerging Asia has been growing faster than we had expected so far in 2010. And the differences between what these countries are actually producing and what they could produce operating at full capacity—what economists like to call ‘output gaps’—have been closing rapidly. Yet financial conditions remain still quite accommodative (e.g., low interest rates, plenty of liquidity).

So what is the outlook for inflation in the region? If growth continues to be robust, is there a risk that inflationary pressures in Asia could accelerate? Or is inflation in the region still largely a reflection of global food and energy prices—a big share of how consumers in the region spend their money?

Changing inflation patterns

Inflation patterns differ across the region. For example:

But, looking at Asia more broadly, our analysis points to three factors that policymakers should consider as they monitor inflationary pressures.

First, the combination of economic growth rates above a country’s ‘potential’ or full capacity, and easy monetary conditions (such as negative real policy rates) is usually a recipe for inflationary pressures down the road. I realize this might seem like a rather obvious conclusion, and it is. But it is still worth reminding ourselves of it as ‘output gaps’ across the region are closing rapidly (that is, actual output is getting close to its ‘potential’ or maximum capacity based on an economy’s current structure or characteristics).

Second, although supply shocks (such as commodity prices) continue to matter for inflation in Asia, demand factors are also becoming increasingly important. As Asian economies grow and consume more, the role of output gaps in driving inflation rates in the region is increasing. This conclusion, too, might strike one as obvious. But I have heard it sometimes said that Asian inflation mainly reflects supply shocks. While this might have been true in the past, I am not so sure that it is still the case today.

Third, when an economy is close to its ‘potential’, renewed pressures on global commodity prices may be more likely to add to inflation. At these times, firms find it easier to pass onto consumers increases in production costs. Moreover, if emerging Asia continues to grow rapidly, this may also lead to higher commodity prices, as demand from the region has become an important driver of many of these prices.

The policy implications for the region are evident.

If domestic demand pressures continue to become a bigger factor in core inflation, it will become increasingly important to step up the pace of policy normalization. In fact, this process has already started in many Asian economies, with central banks having raised their policy rates and reserve requirements since late 2009.

However, as I said before, the surge in capital inflows we have witnessed in recent months can be a complicating factor. For example, by depressing local long-term interest rates, this can undermine efforts to tighten the monetary stance through policy rate increases. Still, monetary tightening has an important role to play in managing the influx of liquidity associated with those inflows, particularly given prospects for monetary easing in advanced economies and the generally limited flexibility of exchange rates here.

In my view, continuing with recent steps to allow for stronger currencies would be more conducive to normalizing the policy stance and would also be more effective in managing volatile capital inflows.

However, structural factors—such as better growth prospects and stronger policy fundamentals than in advanced economies—mean that capital inflows into emerging Asia are likely to remain strong over the medium-term. This will require policies to better absorb such flows, including deepening of financial markets, and channeling such flows towards financing broader-based growth and much needed infrastructure.