Column The Asian tightening

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: With Tuesday’s 50 bps increase in the repo rate, RBI has hiked the policy rate by 125 bps since June 11, more so than other regional central banks. While regional inflation rates range from 5% in Taiwan to nearly 12% in India, so far this year the central banks of Philippines and Indonesia have hiked the rates by 75 bps, the Thai and Taiwanese central banks by 25 bps while other Asian central banks have remained on hold.

But Asian monetary policies generally appear tighter and more likely to be tightened compared with advanced economies. This reflects generally lower inflation and greater financial fragility in advanced economies than in Asia.

It is well known that consumers in countries with higher income per capita tend to spend a smaller share of their income on food and energy. Hence, the impact of higher food and energy prices on consumer price inflation is smaller.

In addition, the corporate sector of advanced economies is less energy intensive than that of emerging markets: this reflects the smaller share of the manufacturing sector in advanced economies as well as their generally less commodity intensive nature. As a result, a commodities price shock has less of a negative impact on supply in advanced than emerging economies. This is an important difference as oil prices impact inflation much more through the supply side than through demand side—the weight of energy in consumer price indices is much smaller than the share of energy in manufacturing costs. When costs rise, in order to stay profitable, the corporate sector has to lower its output and, to the extent allowed by demand, to raise its prices. That is why the ongoing oil price shock has translated globally into a combination of slower growth and accelerating inflation.

And most importantly, the epicenter of the ongoing financial crisis is in advanced rather than emerging market economies. In countries such as the UK and US, monetary policy not only reflects inflationary pressures but also financial fragility. The Fed funds rate, the US policy rate, when deflated by the consumer price index, is negative 3%, not high enough to contain inflationary pressures. But when deflated by the US house price inflation, which is currently negative, the real Fed funds rate is a whopping 18%! This reflects that two objectives, inflation and financial stability are being targeted, with only one policy instrument, interest rates. Recapitalisation and restructuring of financial sectors have been left to market forces, with government intervening merely to limit the systemic risks created by unfolding market events. As a result, financial fragility lingers on and this limits the ability of central banks in advanced economies to tighten policy enough to lower inflation.

For Asian central banks, looser monetary conditions in advanced economies could make the task of containing inflation more complicated. That is because, as a result of years of liberalisation of capital accounts and domestic financial markets, monetary conditions in the region tend to be influenced by monetary conditions in advanced economies, especially the US.

Of course, the degree of influence of the US monetary policy varies across countries—in Singapore and Hong Kong, two regional financial centers, onshore interest rates fully reflect foreign interest rates adjusted for currency expectations. At the other extreme, China still has stringent capital controls and undeveloped capital markets. As a result, US monetary policy tends not to have a large impact on Chinese monetary conditions. India is somewhere in between these two polar cases: capital inflows and outflows have increased to 96% of GDP in FY08 from 15% 10 years earlier but India maintains an array of capital controls that limits the transmission of US monetary conditions to the Indian economy.

The global economic backdrop remains inflationary: while broad commodity price indices have been falling by about 10% in July, this follows an increase of 31% since the beginning of 2008. And oil prices, that were one of the key drivers of the July commodities price decline, have been stabilising over the past week. Even after a downward revision last month the IMF still projects global growth at 4.1% this year and that most important driver of commodity prices, emerging market growth, at 6.9%.

Sooner or later, a number of Asian central banks are likely to feel compelled to follow the example of RBI and hike rates aggressively. The risk is that, with open capital accounts, tightening monetary policy in Asia when major central banks are on hold could attract foreign liquidity inflows. In turn, this could fuel monetary growth and actually add to inflationary pressures. It may be that bringing down Asian inflation could require currency appreciation as well as interest rate hikes.