While Asian central banks cannot afford to ignore inflationary pressure, monetary tightening can take place gradually.
Tai Hui
Chief Market Strategist
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In brief
- Economic recovery in Asia is persuading central banks in the region to start raising interest rates.
- Fewer signs of overheating and limited currency depreciation mean Asian central banks can tighten at a less aggressive pace compared with the Federal Reserve.
- Higher rates should support Asian currencies. Duration risk in Asian fixed income should be offset by credit spread tightening and yield income.
Asian inflation is accelerating
The Federal Reserve (Fed) is on an accelerated path in terms of policy rate increases, as well as beginning its balance sheet reduction. One question is whether Asian central banks will be following the Fed? Several central banks in Asia, such as India, Singapore, and Taiwan, have already raised their policy rates or adopted more restrictive monetary policy. More central banks in the region are expected to join this group in the coming months. However, their pace of tightening should be modest compared to the Fed’s.
The risk of accelerating inflation is clearly on top of central bankers’ minds in Asia, as well as around the world. The sharp rebound in food and energy prices has pushed Asian inflation higher. In some cases, such as India, the Philippines, South Korea and Thailand, the latest headline inflation is above their central banks’ targets. According to the Food and Agriculture Organization of the United Nations, the composite food price index has risen by 23% in May versus a year ago. Meanwhile, Brent crude oil is 70% higher. This would feed directly into headline inflation in the months ahead.
However, central banks’ view on whether higher rates can help to address this problem is mixed. In fact, some would argue that more expensive food and fuel are a risk to consumption since many Asian households spend a high proportion of their income on these necessities, which in turn leaves less money for other discretionary items.
A more important argument in supporting higher rates is that domestic economic recovery is taking shape. More economies in Asia are now adopting the “live with COVID-19” strategy and reopening their domestic economy, as well as allowing more foreign travelers to enter. Retail sales in Malaysia, Singapore and Thailand are returning to pre-pandemic level. If the experience of the U.S. and Europe is a guide, we could see local consumers switch from goods to services, possibly lead to more demand-side inflation pressure.
Exhibit 1: Central bank movements and forecasts
Changes and forecasts in central bank key policy rates
Source: Bank of International Settlements, J.P. Morgan Economics, J.P. Morgan Asset Management.
Data reflect most recently available as of 06/06/22.
But Asian central banks can afford to be gradual
While Asian central banks cannot afford to ignore inflationary pressure, monetary tightening can take place gradually. The U.S. government went through an aggressive spending plan in 2020 and 2021 to support the economy. Although Asian governments also adopted economic stimulus in 2020, most of them scaled it back in 2021, so the pent-up inflationary pressure is smaller. Moreover, wage inflation in Asia is modest compared with the U.S., this also helps to contain the wage-price inflation spiral.
Historically, Asian central banks tracked the Fed in a rate hiking cycle to protect their currency from excessive depreciation. While the U.S. dollar has strengthened in 2022, Asian currencies did not face significant depreciation pressure. In fact, most Asian currencies outperformed the euro and the Japanese yen since the start of the year.
There was sufficient yield differential between local government bonds against U.S. Treasuries to limit Asian currency depreciation. Many Asian currencies, especially in southeast Asia, are undervalued while operating a healthy current account position. Reduced currency depreciation risk mean that Asian central banks have more flexibility in setting policy rates according to domestic condition.
Investment implications
As Exhibit 1 shows, most Asian central banks are expected to raise interest rates modestly for the rest of this year, with the notable exception of China, Japan and Thailand. This should help to further stabilize Asian currencies and enhance the appeal of Asian equities and fixed income to international investors.
Higher policy rates would introduce some duration risk to Asian fixed income. This could potentially be offset by spread tightening, driven by local economic recovery and income generated from these assets. Even as risk-free rates globally have risen, the demand for income remains strong. Asian fixed income could meet investors’ need for yield as they adjust their portfolios to a more balanced position between equities and bonds.
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