ADB prods emerging Asia to take inflation threat seriously

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Emerging Asia needs to adapt to a 'new reality' of persistently high commodity prices and cannot let up on fighting inflation despite weak growth in advanced economies, the Asian Development Bank said in a report released on Thursday.

In its Asia Economic Monitor, the ADB also repeated its call for regional policy coordination, arguing that closer cooperation would allow for faster currency appreciation without jeopardising trade.

It said cooperation could begin "informally" through dialogue among policymakers and then "evolve into deeper forms of co-operation in the long run."

The bank found growth had slowed across the region, partly because of tighter monetary policy aimed at cooling inflation and partly because of poor growth in quake-hit Japan and the United States. ADB did not update the growth forecasts it gave in April.

Inflation remained stubbornly high even though commodity price pressures have eased from an early May peak, and ADB warned against complacency.

"Policymakers should be careful not to over-react to the slowdown in advanced economies, as regional growth remains resilient and inflation a continuing problem," it said.

Emerging Asia recovered rapidly from the financial crisis, and spare capacity has evaporated in many countries. Tight labour markets make the region vulnerable to a "vicious" wage-price spiral where rising prices prompt workers to demand higher pay, which in turn leads companies to raise prices, ADB said.

'BENIGN NEGLECT'

The report included an entire page filled with examples of steps Asian countries have taken to try to cool inflation, ranging from traditional measures such as interest rate hikes to more narrowly targeted ones including China's efforts to raise pork production.

Each country has its own "optimum mix" of monetary, fiscal, financial and exchange rate policies, it said. Capital controls could be part of the mix, although ADB gave that only a lukewarm endorsement. Echoing the International Monetary Fund, ADB said capital controls can turn off investors and should be well targeted and temporary.

It said countries that intervene in foreign exchange markets could allow for "somewhat faster" appreciation, which would help to dampen inflationary pressures.

But it said the region's policymakers appeared to be adopting a "benign neglect" approach when it comes to commodity-driven inflation, and that may be a mistake.

"It has been increasingly difficult for the region's central banks to defend a 'benign neglect' approach when energy and food prices trend up rapidly and account for a substantial share of (consumer price indexes)," ADB said.

"Traditional core inflation measures become increasingly divorced from reality and monetary policy credibility risks being challenged."

Some central bankers, including the U.S. Federal Reserve, prefer to track "core" inflation which strips out volatile food and energy prices, arguing that this gives a better read of underlying inflation trends. But ADB said that may not apply to emerging Asian economies.

Food and energy account for a much larger share of the consumption basket in emerging markets than in advanced economies, and demand is exceptionally strong, so rising prices cannot be easily dismissed as transitory.

The report also poked holes in the widely used argument that monetary policy is ineffective against commodity prices because they are set in global markets, and rate hikes work too slowly to combat short-term price swings.

A willingness to tighten in response to inflation surprises can help anchor inflation expectations and reduce the risk that headline inflation pressures spill over into core, ADB said.

Asian policymakers could also make better use of foreign exchange rates to tackle commodity-driven inflation.

The report found emerging East Asian economies with the largest exchange rate appreciations tended to have somewhat lower rates of domestic food and energy prices.

"At a minimum, policymakers may face the challenge of responding to more episodes of commodity price surges and continued high price volatility," ADB said.

"But it is also possible that a 'new normal' may evolve with sustained and high commodity price inflation."