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By Frederic Neumann of HSBC
It's easy to shrug off the current spike in inflation as temporary. Food prices, after all, tend to settle rather quickly once the weather calms and farmers take their cue. Energy costs, too, may begin to ease when the Middle East regains stability. So, why hike rates if the current price shock is bound to fade in a few, short months?
Because this isn't your classic headline scare. In Asia, core prices are rising equally fast.
Take China: yes, January's inflation print was a little lower than everyone had feared. But, worryingly, non-food inflation now outpaces food inflation, on a sequential basis. Elsewhere, the picture is much the same: over the last several months, core prices have soared across Asia. Therefore, the current bout of inflation will carry on for far longer than most recognise, and urgently needs the attention of the region's central banks.
The jump in core inflation may seem puzzling. The West, despite its recent revival, still grapples with huge unemployment and it's hard to see core prices becoming a major headache there any time soon. With globalisation linking us all by the hip, how can core inflation then become a problem in Asia? Because the world has changed: Asian economies have matured, driving their own growth and no longer boast the excess capacity that once led them to export disinflation in the form of cheap clothes and affordable electronics.
Just look at labour markets. With plenty supply of potential migrants in rural areas, it's no wonder that the region saw little wage pressures over recent decades. No longer. Demand for workers is now so rampant that factories complain of shortages. This, inevitably, has led to accelerating wage gains, and employers understandably take every opportunity to pass on higher costs. Note that this is not just happening in China: skilled workers also go for sharply rising premia in India, Southeast Asia, South Korea, Taiwan, and Hong Kong.
This is not a short-term blip. Something more fundamental is going on here. Since the 1980s, core inflation rates have declined, and converged, across the world. Globalisation, in effect, was held responsible, along with more prudent central banking, for this Great Moderation. But, crucially, the data is now pointing into a different direction. Since about 2003, core inflation rates have once again started to diverge globally, staying subdued, if not falling further, in advanced economies, but trending up, and becoming far more volatile, in emerging Asia.
There are two lessons here. One short-term, the other long-term. First, policymakers and investors need to shake off the belief that the current inflation spike is temporary. Even if food and energy costs were to temper in the coming months, core price pressures will still pick up unless growth falters. Therefore, interest rates need to rise from their near emergency lows. China has already made a start, and India has hiked more than others. But much more needs to be done here, while in most of southeast Asia the tightening cycle has barely begun.
Second, if core prices are decoupling from the West, structurally and not just cyclically, then so should monetary policy. This, of course, is easier said then done for it requires not only a fundamental adjustment in the conduct of central banking, but also far more flexible exchange rates than the region currently boasts. If Asia fails to take the plunge, it will have to live structurally with much higher rates of inflation than it is accustomed to. Letting exchange rates float may ultimately be the more palatable option.
Frederic Neumann is co-head of Asian economics research at HSBC
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