Asia’s tightening cycle could last longer than what is currently priced in by the market.
Recent stability in the price of commodities indicates inflation across a handful of economies in the region may peak over the next two to three months. But peak inflation is not a sufficient condition for central banks to stop their tightening cycles.
Not only will the transition from peak inflation to official target ranges be prolonged, hawkishness from the US Federal Reserve will become an important consideration for regional central banks.
Interest rate differentials with the US in the region are low compared with recent history. The failure to follow the Fed can only exacerbate currency depreciation and/or accelerate a decline in FX reserves.
If anything, ANZ Research believes the odds are for regional tightening cycles to be more drawn out than is currently anticipated.
Crude oil prices have steadied and food prices are now down around 12 per cent from their peak in March. As both food and fuel carry large weightings in the CPI baskets, their price surge had a substantial bearing on inflation.
Recent data suggest food and transportation costs directly linked to crude oil prices have been the dominant driver of inflation in Thailand, India, the Philippines, South Korea, Indonesia and Malaysia. The contribution has been the highest for Thailand and least for South Korea.
Food has made a larger contribution than fuel in all economies except South Korea. In ANZ Research’s view, this reflects the larger weighting of food in the CPI basket as well the bias of governments to control domestic fuel prices.
Strict price controls on domestic fuel prices have ensured relatively moderate headline inflation in Indonesia and Malaysia.
Malaysia’s inflation has also benefited from wider price controls on various food items. Depending on fuel prices adjustments, overall inflation could still rise. ANZ Research is more confident calling peak in inflation in the economies seeing a stabilisation of oil and food prices.
Non-food and fuel inflation will be stickier. Still, other indicators such as shipping costs and prices of semiconductors, which feed into a broad range of electronic products, have also been on the decline, and suggest peak inflation pressures, at least for goods, are behind us.
Several economies are starting to see a turnaround in their producer price indices (PPI). Coupled with businesses passing on some of the increments in input costs to consumers in recent months, the PPI-to-CPI ratios have started to ease.
To be clear, price pressures in the pipeline remain elevated, but the adjustment is now underway in most economies. Furthermore, available surveys on consumer sentiment suggest there are more pessimistic than optimistic consumers, in turn suggesting household demand will remain restrained.
There has been a material deterioration in consumer expectations in South Korea, where rate hikes started the earliest and where the highly leveraged household sector is more exposed to the double whammy of high inflation and rising debt servicing burdens.
Indonesia is the only economy where consumer confidence is in positive territory, but even there, sentiment has started to soften.
Inflation will not quickly slip from its peak rate into official target ranges. A correction of this magnitude is likely to be feasible only in the second half of 2023 in most economies.
Inflation forecasts do not provide flexibility to halt the tightening cycle, although there may be some scope to reduce the size of individual hikes.
Additionally, central banks can no longer choose to run policies independent of US Fed action without risking further currency depreciation. US policy is slowly but surely becoming more explicit in central bank policy reaction functions in the region.
The Fed’s inclination to continue with rate hikes even with slowing growth/higher unemployment has a bearing on regional monetary policies, at least to the extent that it alters their own growth-inflation trade-off.
Notably, the Fed’s aggressive policy normalisation has resulted in a sharp narrowing in the region’s policy rate differentials with the US. As things stand, the spread between most economies’ policy rate and the FFR is between 1.4 to 3.4 standard deviations below their five-year averages.
South Korea, which started its rate-hiking cycle two quarters ahead of the US, is the only exception, but this buffer is set to diminish given the Bank of Korea’s limited appetite for jumbo rate hikes.
Meanwhile, real policy rate buffers across the region have mostly thinned significantly as inflation picked up. On this measure, the pressure for rate hikes is the strongest in Indonesia and Thailand, which have been the slowest to commence their respective rate lift-offs.
Headline FX reserves across the six nations in question have fallen by 5 per cent to 10 per cent of their end-2021 values during the first seven months of 2022. This is comparable to the drawdown at the peak of the global financial crisis (GFC) in 2008.
To be fair, it’s estimated roughly 40 per cent of this fall can be attributed to valuation losses. Still, even after excluding the valuation effect, Asian central banks have deployed significant ammunition to fight FX depreciation pressures.
ANZ Research estimates for the six economies under study suggest combined FX sales of roughly $US75 billion were carried out between January and July, marking one of the most aggressive episodes of intervention in recent history.
This fall in FX reserves has weakened external health metrics, even though they are comfortable on an absolute basis. Notably, import covers for India and Malaysia have fallen even below the level seen during the peak stress in the 2008 GFC.
It is too soon to call the end of balance-of-payments strain in the region. The terms of trade remain unfavourable for the region’s net energy importers, while a downturn in the tech cycle bodes poorly for the region’s electronic exporters.
Krystal Tan is an Economist, Dhiraj Nim is an FX Strategist/Economist & Sanjay Mathur is Chief Economist, Southeast Asia and India at ANZ
This is an edited version of the ANZ Research report ‘Evolving contours of monetary policy’, published August 31, 2022
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