“Ignore risks to price stability at your peril”: HSBC

The bank warns that even though inflation has eased, Asia remains in the grip of a deteriorating growth-inflation trade off.

HSBC comments:

A few, short months ago worries over inflation kept nagging away at all of us. At the time, growth looked robust, yet price pressures were building fast. Now, the worries have shifted. Activity numbers are sagging and inflation has eased off. But it would be a mistake to ignore risks to price stability. Sure, cyclically, slowing growth is taking inflation off the boil.

Structurally, however, Asia remains in the grip of a deteriorating growth-inflation trade off. A perk-up in activity, therefore, will quickly push up prices once more. In a few, short months, therefore, be prepared to fret again about inflation.

Let's start with the good news. Inflation is easing. In Southeast Asia and Korea, headline inflation has come in mostly below expectations. Even sequential core price readings are starting to cool. Central banks are still keeping up the fight, with the BSP hiking only last week and the Koreans taking most - though, respectfully, not us - by surprise in pushing up the policy rate further.

Still, more broadly, inflation has become a less pressing concern for policy-makers. Even the Philippines and Korea may now take it easy for a while. Elsewhere in Southeast Asia, officials can afford to sit back and watch more data flow by before taking another plunge.

In China and India, of course, the story is a little different, perhaps in part because growth never eased as much as in Asia's more trade-dependent, smaller economies. Still, in both cases, the peak to headline readings is near, and, sequentially, price pressures have started to stabilize. The debate, therefore, has now turned to how quickly price readings will fall off.

In China, we suspect, quite quickly, though in India inflation will prove stickier. Both central banks are not quite done tightening, of course, but, broadly, markets seem to have moved on to worry more about growth than inflation in these economies as well.

Our regional Asian Business Index, a composite of HSBC's PMI surveys, shows that both input and output prices are expanding at a much more subdued clip than earlier this year. The global drop in commodity prices in the last couple of weeks, most notably for agriculture and energy, will no doubt help to cool things down further.

Brent oil has dropped by 10% from its high in April and local energy costs will react accordingly. Food inflation, too, has rolled over in most economies, even if China remains one notable exception, with the temporary drought in the south having led to an unexpected upward drift of agricultural prices again in the last several weeks.

So much for the good news. The bad news is that this is all just short-term cyclical stuff. Take a step back. There are two things to consider in forecasting inflation. First, over a period of a few months, the impulse from changes in manufacturing activity and the gyrations of global commodity markets dominate the picture.

Bad harvest, in this context, matter more than growing wage demands and capacity utilization. Second, and over the longer-term, what drives inflation is an economy's ability to mobilize resources to satisfy demand; be it by throwing more workers at an economy or more capital, or, ideally by making it all work more efficiently together.

On this last count, we suspect that Asia's ability to ramp up potential output ahead of actual demand has started to deteriorate. We'll have much more to say about this at a later stage. At this point, however, it suffices to note that two processes are at work. First, a number of Asian economies are gradually losing their ability to mobilize masses of labor cheaply. This dents the ability to push up potential output at the accustomed pace.

Second, and perhaps more importantly, even if potential output growth can be sustained with gains in productivity, demand growth has caught up with production potential. This, of course, is partly by design, with measures having been introduced to stimulate local consumption, and partly due to excessively loose monetary policy.

Granted, it's all getting a touch technical. Our point is this. Don't be fooled by the recent dip in inflation pressures. As welcome as this is, it masks a fundamental deterioration in the growth-inflation trade-off in Asia. Local economies, for structural reasons, are today much more prone to generating price pressures at a given level of growth than, say, over the decade preceding the Global Financial Crisis.

When growth rebounds, and we expect the numbers to perk up quite handsomely in the third quarter, price pressures will rebound as well. In short, be prepared for CPI readings to become an issue again by the turn of the year.