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Keeping Asia from Overheating

Asia’s vigorous pace of growth has seen the region play a leading role in the global recovery. But, there are also now growing signs of price pressure across the region’s goods and asset markets.

Headline inflation in Asia has accelerated since October 2010, mainly owing to higher commodity prices. There are, of course, variations in how much this has affected inflation across Asia, partly reflecting differences in the shares of food and energy items in expenditures.

But there are signs that higher commodity prices are spilling over to a more generalized increase in inflation. Expectations of future inflation have picked up. And accommodative macroeconomic policy stances, coupled with limited slack in some economies, have added to inflation pressures.

So, is Asia overheating? While inflation is generally expected to decelerate moderately in 2012, after first increasing further in 2011, inflation risks remain on the upside. Low inventories and limited scope for supply to respond to higher demand mean that commodity prices are vulnerable to new supply shocks. In addition, persistent concerns about food shortages could trigger an upward spiral in global prices.

At the same time, overheating pressures are building within a few Asian asset markets. There are two telltale signs.

Against this backdrop, the need for policy tightening in Asia has become more pressing than it was six months ago, especially in economies that face generalized inflation pressures. How should policymakers address these challenges?

To conclude, we expect Asia to continue to be a key engine of global growth over the next two years. But with overheating pressures now in clear sight, policies need to be geared toward keeping these pressures from boiling over in a way that could undermine Asia’s economic prospects and, therefore, the global economic outlook.