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Emerging Markets

Vigilance urged on Asian inflation

Asian central banks are being urged to stay vigilant on the medium-term threat of inflation as they are locked in a prolonged period of loose monetary policy.

Asian central banks are being urged to stay vigilant on the medium-term threat of inflation as they are locked in a prolonged period of loose monetary policy.

This week, Indonesia reported 7.3% inflation in April, its lowest level since December 2007, and South Korea announced a 3.6% inflation rate for last month – a 14-month low.

Asian central banks have this year aggressively slashed interest rates and bank reserve requirements to expand credit and boost sluggish growth. Analysts expect Indonesia’s central bank, led by governor Boediono, to ease policy further next week.

Tim Condon, chief economist for Asia at ING, said that although the pace and extent of monetary easing has now begun to slow, the region’s counter-cyclical policy firepower will rely on “prolonged monetary stimulus” as fiscal stimulus wanes.

The proactive Asian monetary response to the crisis has been widely praised, and contrasts with policy impotence during the 1997 regional crisis. But the speed at which Asian central banks have reacted to lower interest rates – although supported by economists - has heightened the perception that monetary policy is still biased towards growth and soft on inflation.

The fear is that this will feed into future wage and price setting behaviour as central banks may lack credibility to anchor inflation expectations.

William White, former chief economist at the Bank for International Settlements, told Emerging Markets: “Asian central banks – like their counterparts globally – need now to look beyond positive short-term boost to economic growth, and look at the longer-term effect of their policies.”

Before the world hurtled to disaster in August last year, the region was besieged by high energy and food prices, and their overheating economies caused high systemic inflation. This triggered a regional monetary tightening cycle from May last year as well as currency appreciation until September.

However, monetary conditions remained effectively loose as real interest rates largely stayed negative. With rates expected to remain low into 2010, Condon fears that Asian central banks will “remain behind the curve on inflation again” once economic activity picks up.

Central banks try to target interest rates by balancing the need for price stability with potential output. However, the unprecedented financial and economic turbulence has “undermined confidence in predicting short- and medium-term growth,” White said.

As a result, central banks may overshoot with loose monetary policy, in response to high expectations of Asian growth rates.

Once the region regains its growth momentum, there are predictions that inflation “may take central banks by surprise” as producers reinvest, domestic consumption increases, and supply-side pressures such as higher energy costs kick in, Condon said.

In addition, with inflation falling on the collapse in commodity prices last year, central banks may have concluded that monetary policy is essentially impotent in addressing exogenous shocks. This is the view that so-called supply-side pressures from high commodity prices are temporary in nature and so higher interest rates will not significantly affect core prices.

This contrasts with the more hawkish view that strong domestic demand significantly fuelled inflation in Asia in 2007-08 and the distinction between demand and supply-side shocks is too simplistic given the overlapping nature of structural, cyclical, domestic and external price pressures.

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