Until now, we have ardently stressed the view that Asia's inflation dynamics have structurally deteriorated. The growing bias of growth towards domestic demand and high commodity prices, which have partly been driven by regional demand itself, were two critical forces that were structurally buoying up inflation.
But both forces have weakened – commodity prices and energy prices have softened substantially, whereas domestic demand growth has moderated to trend. We are therefore moderating our stance on inflation.
However, this moderation is unlikely to much increase the space for rate cuts largely because of already existing generous monetary conditions. Central banks are most likely to preserve their limited policy space for events such as a severe dislocation in financial markets.
Drop in commodity prices
Commodity prices have come off sharply from their 2011 peaks. Food prices have come off by roughly 9% and metal prices by 20%. Crude oil prices are down almost 22% from their highs in 2011. This drop in commodity prices is likely to be more sustainable than in the past, as it is partly attributable to a moderation in fixed asset creation in China and the rest of the region.
In general, fiscal policy in the region, which traditionally has embodied a fair degree of national infrastructure spending, is also turning cyclically more restrictive. The fiscal impulse, a metric which very simply measures whether fiscal policy is adding or subtracting from aggregate demand pressures in an economy, is forecast to be smaller or negative.
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More restrictive fiscal policies and slower infrastructure spending are a critical influence on commodity prices as the feedback effect of Asian demand on global commodity prices has increased over the last few years. Asia now accounts for roughly a quarter of global oil consumption and around half of metal consumption.
Only in the Philippines and Thailand is the fiscal impulse expected to be higher – higher infrastructure spending in the former and post-flood reconstruction in the latter. Both economies are, however, not large enough to influence commodity prices.
Regional inflation
Easing commodity prices should have a significant impact on regional inflation. At 40% and 10%, respectively, the weightings of food and energy are higher in Asian inflation baskets in comparison with both developed and emerging markets. The sensitivity of inflation to energy prices is, therefore, high.
Our estimates show that a US$10/barrel drop in oil prices from a base level of US$120/barrel would lower inflation by 0.5% to 1.5%. At a broader level, the IMF has estimated that roughly 55% of the region’s inflation is attributable to supply-side shocks.
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The relationship between headline inflation and core inflation in Asia is also tight, implying that persistent commodity price pressures can feed through core inflation via inflation expectations, wage indexing and so on.
In the current context, two developments are noteworthy. The first is on inflation expectations. Though minimum wages have been increased in some countries, including China, Hong Kong, Malaysia and Thailand, the impact appears to have fully played out. Inflation expectations have generally subsided or, at least, have come off from their highs.
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The second noteworthy development is that growth momentum has eased, with output gaps narrowing over the last two quarters or so. Intuitively, this narrowing suggests that the ability of the corporate sector to pass on even the more moderate input costs has become constrained.
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The narrowing of output gaps has not been uniform and has been slower in Indonesia, Malaysia and the Philippines. Nonetheless, contemporaneous data points such as credit and auto sales growth suggests that there is a high probability of this development panning out over the next couple of quarters.
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Overall, the simultaneous dissipation of supply side pressures as well as narrowing of output gaps should contribute to lower inflation. Current trends in inflation (and not just annual year over year comparisons which tend to be optical in nature) are consistent with the evolution of these two forces.
Country-level inflation
However, as mentioned earlier in the report, intra-regional differences do exist and the pace of inflation correction will also vary. Our analysis shows that India, Indonesia and Singapore are the three main laggards to the regional trend of moderating inflation largely due to idiosyncratic factors.
In India, rupee depreciation has slowed the pace of correction in inflation, even though growth has come off sharply. For example, oil prices in local currency terms have remained elevated relative to dollar denominated prices. This inconsistency should even out as the currency stabilises. Moreover, the fall in international crude prices will reduce the degree of domestic price adjustment, most likely due in June.
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Singapore’s inflation dynamics are probably more unique. They are predominantly related to the government’s decision to reduce the dependency on low earning foreign workers by both lowering administrative ceilings on foreign worker dependency ratios and increasing levies.
In Singapore, employers are required to pay an administrative levy to the government for hiring foreign workers. Indonesia’s slow decline is more simply related to the persistence of strong domestic demand conditions.
No monetary easing
This on-going and expected decline in inflation is however, unlikely to release much space for monetary easing. The problem is that most central banks were slow to normalise rates post the global crisis and as therefore, the incremental latitude is limited.
On Taylor rule based estimates, admittedly not a perfect measure for a developing economy, current policy rates remain lower than implied levels. Moreover, real rates remain significantly lower than pre-crisis levels and as such are supportive of growth.
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The only candidate for meaningful rate cuts is India, and that by 50 basis points. In terms of timing, the second half of FY13 (fiscal year ending March 2013) appears appropriate as the INR depreciation effects and domestic fuel price hikes would have been fully digested (for now, this is not captured in Taylor rule analysis).
For the rest, central bank talk is likely to be recalibrated with the focus shifting away from balancing growth and inflation concerns to supporting growth. Only a severe dislocation of financial markets will likely prompt central banks to meaningfully ease.
However, what central banks are likely to be able to convey is that currently accommodative monetary conditions are likely to be durable. In short, lower for longer will be the principal message. This should remove policy related risks on the fixed income market.
About the Author
This article is excerpted from “Top View Asia: Inflation on the Backburner,” a report by Royal Bank of Scotland and affiliated companies that was published on 15 May 2012. It has been re-edited for clarity and conciseness.
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