For the first time since the early 1980s, inflation has reached troubling levels around the world. As a result, financial markets are becoming increasingly nervous that monetary tightening by central banks, especially by the US Federal Reserve, could create challenges.
We can see two sets of such challenges for countries in Asia. First, they will have to contain the fallout of rising global prices on their economies. Secondly, they will have to buffer their economies and financial systems from potential shockwaves from higher interest rates and tighter money in the US.
Inflation perks up
In the US, consumer prices rose 7.9% in February over the previous February – an annual rate that was much higher than the 2.1% average in 2018 and 2019. A major factor behind these price pressures has been the crisis in Ukraine.
The fear of disruption to oil and gas supply has caused energy prices to soar. Wheat, barley, sunflower seed oil and other food items, food prices have also spiked.
But inflationary pressures had been building up even earlier, suggesting that other factors are at play. Some argue that central banks in major economies had been too slow to bring interest rates back up to normal levels once the worst impact of the pandemic on economies had been contained.
Others point to persistent dislocations in supply chains leading to rising prices. Shortages of shipping capacity and semiconductors, for example, have led to surging freight charges and chip prices.
Asia’s governments can respond by capping the rise in food and energy costs using fiscal subsidies and regulations
The upshot is that inflation is likely to remain at elevated levels for much of this year. Should the dislocations in supplies of vital goods and the bottlenecks in supply chains sort themselves out by the later part of 2021, as we believe, we should see inflation rates beginning to ease by year-end.
In Asia, prices have indeed risen, though not as steeply as in the US. Governments can respond by capping the rise in food and energy costs using fiscal subsidies and regulations so as to protect the living standards of their citizens.
But this cannot be taken too far without undermining fiscal positions and creating distortions in the economy. As time goes on, inflation rates in Asia will pick up further and policymakers will have to look at other options.
Policymakers in many jurisdictions are clearly determined to use tighter monetary conditions to bring inflation down. The statements emerging from the US Fed are quite clear: the policy rate will be raised aggressively in coming months.
Consequently, there will be pressures on the region’s central banks to also raise rates – or face the risk of capital outflows as investors seek higher returns in US dollar-denominated assets. In the end, Asian central banks will have little choice but to raise their policy rates as well, otherwise capital flight will create financial risks.
So far, South Korea and Singapore have moved fairly aggressively to tighten monetary policies
So far, South Korea and Singapore have moved fairly aggressively to tighten monetary policies, and have signalled that they will continue to do so until inflation is under better control. By the second half of this year, we see central banks in India, Malaysia, Indonesia and the Philippines also following suit. Only Thailand may hold out, given the continued weakness in its economy.
What are the risks?
Because of the immense uncertainty over where economic growth and inflation are actually heading, there is a material risk of policymakers misjudging the quantum of monetary tightening needed and perhaps overdoing it.
It is impossible to say with confidence, for example, how serious the current spike in Covid infections might get and to what extent restrictions will impact Chinese economic growth and global recovery.
Neither can we predict how much of a supply response there will be in the oil market; we simply do not know by how much US shale producers will increase production.
Given this backdrop, the cautious and calibrated approach taken by Asian central banks probably makes sense as the best way to contain price pressures and provide some resilience against potential financial stresses that may arise from global monetary tightening.