(July 14): Extreme weather, the Covid-19 pandemic, lockdowns in China, and Russia’s invasion of Ukraine have combined this year to distort global supply chains and send prices soaring. High inflation is troubling because rising prices erode purchasing power and add to input costs. In 2022, it also exacerbates anxiety within businesses and households that already survived two turbulent years. Many central banks in the Asia-Pacific region have price stability among their mandates, and are scrambling to pull inflation back from multi-year highs by tightening monetary policy.
Given elevated inflation readings across the region in recent months, we’re often asked how long inflation will last.
Estimating inflation persistence
We used an auto-regression model to measure the persistence of inflation. Seasonally adjusted headline Consumer Price Index data from 2000 through to the end of 2019 across various Asia-Pacific economies were used to compute quarter-on-quarter inflation. For all the economies in the study, the correlation between inflation and its lagged term is positive, stable and statistically significant.
This implies that inflation is persistent, meaning that elevated prices in one quarter translate into elevated prices in the next quarter. Secondly, we calculated the half-life of inflation persistence using the coefficients obtained for each selected economy. This tells us how many quarters it takes for inflation shocks to halve, which indicates how sticky inflation is.
Inflation persistence across Asia-Pacific economies
Our analysis suggests that inflation will subside relatively quickly in the region as commodity prices retreat, but country-specific factors could lead to different inflation outcomes. Prior to Covid-19, it took an average of about 10 weeks (0.8 of a quarter) for an inflation shock to lose half its impact in Asia-Pacific economies. Inflation was found to be most persistent in Vietnam, where inflation shocks have had a half-life of about six months. Meanwhile, inflation is has proved less persistent in Australia than anywhere else in the region, with inflation taking about three weeks to halve in impact. Different half-life results can be a function of differences in economic growth, import dependencies and natural resource endowments, and government and central bank policies.
Countries with longer half-lives were emerging economies that grew rapidly over the sample decades. These include Vietnam, China, Cambodia and the Philippines. Between 2000 and 2019, these economies registered average year-on-year growth rates of between 7.9% and 13.9%. Fast economic growth can lead to excess demand and sustained inflation. Volatile exchange rates can also cause inflation to be higher for longer, since they exacerbate imported inflation. Weak or misjudged monetary policy is another factor that can keep prices higher for longer.
Natural resources can protect against inflation
Although Indonesia and Malaysia are developing economies that grew quite strongly in the sample decades, history suggests that inflation is likely to return to more normal readings at a pace akin to that in developed economies. This might reflect the relatively heavy use of government subsidies to keep domestic prices low, thereby reducing inflation persistence. Also, this pair are rich in natural resources, such as energy commodities (thermal coal, oil and gas) and mineral ores (aluminium, iron and nickel). This reduces their reliance on imports and the associated exposure to imported inflation. For instance, Indonesia applies so-called domestic market obligations on a majority of these commodities, requiring businesses to sell a portion of their produce domestically and at a discount to the market price.
Higher inflation persistence in more developed economies, such as Singapore, Hong Kong and South Korea, may be explained by their lack of natural resources, making them price-takers and more susceptible to imported inflation. Furthermore, these economies specialise in high-value-added industries, such as high-tech manufacturing, which often use imported inputs to produce their finished goods.
In Australia and New Zealand, central banks successfully used monetary policy to keep inflation within their target bands over the 20-year window, supported by government policies. This contributed to low inflation persistence in these economies.
An end to climbing energy and food prices
Our baseline assumption is that energy and food prices peak in the next few months and then trend lower, assuming that the military conflict in Ukraine does not escalate. A recent weakening in food commodity prices, most notably for wheat and palm oil, supports our assumption.
The estimates from our model should be treated as the lower bound of inflation persistence due to existing supply-side shocks. This is because the pandemic and Russia’s invasion of Ukraine have heightened downside risks. China’s Covid zero policy complicates matters. Sudden lockdowns in major Chinese cities, temporary factory closures, and disruptions at ports can fan cost-push inflation and exacerbate inflation persistence. Secondly, historical data in our model may not reflect current market dynamics. In the sample period, inflation was largely due to excess demand. Central banks had sufficient policy space in the sense that they could hike interest rates and afford the trade-offs, such as reduced output or rising unemployment. In contrast, supply shocks since 2020 saw cost-push inflation dominate. Central banks are caught between a rock and a hard place. They must choose between increasing policy rates to combat inflation, at a time when economies are trying to get back on their feet after Covid-19 decimated demand, or living with higher prices and de-anchoring inflation expectations. Therefore, even though policy rates are low, central banks may err on the side of caution and hold off on monetary policy normalisation. Indonesia, Thailand and Vietnam are in that
camp. This will in turn translate into higher inflation persistence in those markets as prices will stay high for longer.
Thirdly, inflation expectations have yet to stabilise as households, businesses and policymakers grapple with macroeconomic and geopolitical uncertainties.