What Drives Inflation in Asia and Why it Matters

IMF Blog, November 1, 2010

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Title and author: "What Drives Inflation in Asia and Why it Matters" by Anoop Singh.
Publication date: November 1, 2010.
Related IMF work referenced: Regional Economic Outlook for the Asia and Pacific region, October 2010.
Central question: What is driving inflation in Asia, how will inflationary pressures evolve, and what policy tools should policymakers use to manage the withdrawal of crisis-era stimulus while balancing low inflation and economic growth?

Current assessment: "inflation still isn’t a ‘problem’ in Asia" but "it is on the rise in some countries in the region."
Core inflation risk: Conditions are "ripe for rising core inflationary pressures—that is, inflation excluding volatile items such as food and energy."
Contributing factors:
- Economic activity in much of emerging Asia has been growing faster than expected so far in 2010.
- 'Output gaps' have been "closing rapidly" (actual output getting close to 'potential' or maximum capacity).
- Financial conditions "remain still quite accommodative (e.g., low interest rates, plenty of liquidity)."
Outlook question posed: If growth continues to be robust, could inflationary pressures in Asia accelerate, or is inflation still largely a reflection of global food and energy prices?

Heterogeneity in drivers:
- China: "inflation mainly responds to food prices, as the economy’s large capacity to supply other goods and services keeps non-food inflation down."
- India: "although commodity prices are a key factor, both the domestic supply of and demand for goods and services have a significant impact on inflation."
Three region-wide factors highlighted:
- 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."
- Note: 'output gaps' across the region "are closing rapidly."
- 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."
- Third: When an economy is close to its 'potential', "renewed pressures on global commodity prices may be more likely to add to inflation."
- Rationale: firms find it easier to pass onto consumers increases in production costs.
- Additional feedback: "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."

General implication: 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."
- Empirical note: "this process has already started in many Asian economies, with central banks having raised their policy rates and reserve requirements since late 2009."
Complicating factor: Recent surge in capital inflows can undermine tightening by "depressing local long-term interest rates," making policy-rate increases less effective.
- Monetary tightening still important to manage liquidity associated with inflows, especially given prospects for monetary easing in advanced economies and "the generally limited flexibility of exchange rates here."
Exchange rate policy: "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."
Medium-term structural policy needs:
- Recognize that "capital inflows into emerging Asia are likely to remain strong over the medium-term" because of "better growth prospects and stronger policy fundamentals than in advanced economies."
- Required policies to absorb flows:
- "deepening of financial markets,"
- "channeling such flows towards financing broader-based growth and much needed infrastructure."

Author: Anoop Singh — November 1, 2010