While energy and commodity price hikes have been important in kickstarting inflation globally, it is core inflation that is crucial for inflation prospects in the coming 18 months. Core inflation--the gauge of underlying inflation pressure excluding volatile energy and food prices--is also key for monetary policy. Underlying inflation varies across the Asia-Pacific region; in most economies it is lower than in the U.S. This has important implications for monetary policy prospects and, possibly, currencies.

High inflation has become a serious economic problem, globally.  It erodes purchasing power and forces central banks to hike interest rates, thus slowing economic growth. With headline consumer price index (CPI) inflation at 9.1% in the U.S. and 7.6% in Germany in June, financial markets are anxious about inflation prospects (see chart 1).

While CPI inflation is not as high in the Asia Pacific region as in the U.S. and Europe, it has risen.  The weighted average of the 14 economies we cover in Asia-Pacific reached 3.9% in mid- 2022, from 2.5% in end-2021. Consumer inflation exceeds (upper bounds of) central bank targets in Australia, India, Japan, New Zealand, the Philippines, South Korea and Thailand.

Hefty hikes in energy and commodity prices have contributed substantially to the increase in consumer inflation.   Energy and food have significant weights in consumer baskets, with the latter especially high in developing economies. Even before the Russian invasion of Ukraine, energy and other commodity prices were rising strongly as many economies were recovering from COVID downturns. The conflict pushed them to yet higher levels (see chart 2). In addition, the supply chain and transport constraints that drove up prices of goods during and after the COVID crisis were to some extent also cost-push effects, although it is hard to disentangle demand and supply factors during this unusual process.

Chart 1

Chart 2

The role of energy and commodity prices should not be overestimated.   In most Asia-Pacific economies energy and food inflation is relatively modest, in part because of government policies such as administrative price-setting (see chart 3). Also, international prices of energy and other commodities don't continue to rise forever--they stop rising eventually. Indeed, most commodity prices have started falling since June.

Most importantly, if such "cost-push" price rises don't lead to significant increases in inflation expectations and core inflation, the price pressure passes without raising CPI inflation for more than a transitory period, if at all. In such circumstances, credible central banks can "see through" the energy and commodity price hikes and refrain from tightening policy.

This is what happened during previous episodes with surging energy and commodity prices such as 2007-2008 and 2011-2014. CPI inflation then didn't rise much in developed economies and, once the higher oil and commodity prices had worked their way through the system, CPI inflation returned to the low rates it had been at before. Meanwhile, central banks left policy rates unchanged.

It is the rise in core inflation in several economies that distinguishes the current episode from previous experiences with surging energy and commodity prices and that has prodded central banks to lift rates rapidly.   In the U.S. and, to a lesser extent, Europe and some Asia-Pacific economies, core inflation has recently taken off substantially more than during previous periods with surging energy and commodity prices in the 2000s and 2010s (see chart 4). One factor has been supply-chain friction during and after the extraordinary COVID crisis. But it is also clear that inflation pressure has become broader and more persistent this time. With tight product and labor markets, more firms pass on cost increases and more employees gain wage increases to offset the price rises.

Chart 3

Chart 4

Once these dynamics are set in motion they are hard to stop. If not addressed, they could lead to the kind of price-wage spirals that haunted developed countries in the 1970s and that many emerging market economies have faced more recently.

The rise in core inflation in the U.S. started in the spring of 2021, at a time that the economy began to recover from COVID lockdowns and the impact of major fiscal stimulus kicked in. With little slack in the economy and low unemployment, core inflation increased steadily since then and was around 6% by mid-2022.

The U.S. Federal Reserve seems to have been slow in acknowledging the high level of core inflation. With a lag, it has turned more hawkish in order to reduce domestic demand to contain pass-through and wage rises. We now expect the Fed to raise the federal funds rate above 3.5% by mid-2023.

Pressure From Core Inflation Differs Across Asia-Pacific

The U.S. inflation picture is in the limelight and matters-greatly for the region because it influences the U.S. Federal Reserve's policy. But for many Asia-Pacific economies it is not representative. Reflecting different economic conditions, core inflation is generally lower, even in the developing ones (see chart 5). That has a bearing on the monetary policy decisions that have taken place and can be expected (chart 6).

In some APAC economies, the inflation picture is close to that in the U.S.   In India and New Zealand core CPI inflation was around 6% in mid-2022, as high as in the U.S. In New Zealand, the reasons behind elevated core inflation are the same as in the U.S. With little slack in the economy and a tight labor market--New Zealand didn't suffer as much of an economic downturn because of COVID--the cost increases have triggered pass-through and wage increases.

India's case is different. Core inflation is traditionally relatively high in the country. There is now in principle significant slack in the economy, as GDP is far below estimates of the pre-COVID trajectory of potential output. But, in part because of a relatively unresponsive supply side, core inflation is rising rapidly anyway.

At the other end of the spectrum, in some Asia Pacific economies core inflation has remained low.   This is generally amid relatively muted domestic demand in economies where the recovery from COVID has not yet completed. In some, a relatively responsive supply side also helps absorb demand pressure. China is a prime example. Domestic demand has been hard hit by COVID lockdowns and restrictions, even as supply in the economy is holding up amid a focus by governments and companies to keep production going. In these conditions, core inflation was only 1% in June and headline inflation is unlikely to significantly exceed the People's Bank of China's 3% target.

Japan's headline inflation was 2.3% in mid-2022 because of the higher energy and commodity prices. But so-called "core core" inflation, which excludes energy and food, was running at 1%. With wage growth in Japan's large service sector unlikely to rise significantly, we agree with the Bank of Japan that headline inflation is likely to fall below 2% again in 2023.

In Indonesia, government policies to cap energy and food price increases have combined with remaining slack in the economy to contain core inflation at 2.6% through June. In Thailand, a large degree of slack has kept core inflation at 2.5% through mid-2022 even as large energy price hikes drove up headline inflation to 7.7%. In Taiwan core inflation has also remained at about 2.5%.

In the middle of the spectrum, in South Korea and Australia core inflation has generally been rising significantly as of late.  In South Korea, it has risen steadily to 4.4% in mid-2022, from 2.7% in end-2021. Australia, like New Zealand, only has quarterly CPI data; core inflation in Australia was 4% in end-March, although it is likely to have risen further in the second quarter.

Central Bank Policy Is Broadly In Line With Core Inflation Pressure

Largely in response to high inflation, the Reserve Bank of New Zealand has been among the most hawkish developed market central banks, having starting hiking its policy rate in October 2021 (see chart 6). Starting from a higher level, the Reserve Bank of India started lifting rates later. But we expect significant additional increases in policy rates there.

On the other hand, amid economic weakness, the People's Bank of China has eased monetary conditions and is supporting credit growth, although it is reluctant to cut interest rates substantially for fear of stoking capital outflows. The Bank of Japan reaffirmed its commitment to very easy monetary policy despite a more hawkish U.S. Fed. With underlying inflation pressure subdued, the BOJ won't raise its policy rate any time soon, we believe. While the ensuing weakening in the yen worried some government officials, there is little sign it will affect the BOJ's policy stance any time soon.

While the Taiwanese central bank has raised its policy rate modestly so far this year, the Indonesian and Thai ones have not yet started to lift their rates; although Bank Indonesia has begun to unwind some of the government bond positions it had accumulated via quantitative-easing operations.

The Bank of Korea was early in starting to normalize policy and has tightened conditions by a relatively large amount. The Reserve Bank of Australia commenced later but is on course to raise rates significantly.

Chart 5

Chart 6

A Less Hawkish Monetary Stance Vs. The U.S. May Weaken Currencies

In the Asia-Pacific economies where core inflation pressure is lower than in the U.S., policy rates may not rise as much and as fast as in the world's largest economy. As illustrated by the sharp depreciation of the Japanese yen this year, this could lead to more pressure for capital outflows and currency depreciation. Nonetheless, good growth prospects and a comparatively large proportion of equity-based capital flows relative to bond flows should dampen such pressure in several other regional economies. Relatively rapid growth has helped attract foreign capital to the Asia-Pacific region in recent decades.

Major economic impact from the COVID pandemic weakened the region's relative performance in recent years. But we forecast Asia-Pacific GDP expansion of about 4.7% in 2023-2025. The region will keep its status as the world's fastest growing.