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High Inflation and East Asian Countries ' Dilemma
A. The Causes of High Inflation in East Asia
In the decade since the 1997 Asian crisis, East Asian countries, like most of the world, have experienced quite a low inflation rate. Until recently, this positive performance of inflation is partly associated with globalization—defined as “the accelerated growth of international trade in goods, services, and financial assets relative to the rate of growth in domestic trade.” (WEO 2006: 97). According to the WEO study, the main channels through which globalization lowers inflation are as follows:
For emerging economies, particularly Korea, exchange rate appreciation was another important factor that diminished inflationary pressure.
However, lately the inflation rate has been steadily rising in most countries. Figure 1 [ PDF 342.8KB | 1 page ] shows the CPI inflation rate for selected countries for the past 18 months, which clearly reflects that the inflation rate started to increase in most countries in the third or the fourth quarter of 2007.
Why does suddenly high inflation prevail in many economies? Eichengreen (2008) wrote:
As for where this inflation came from, it came mainly from the United States. Starting [in the summer of 2007], in response to the subprime crisis, the [US Federal Reserve] cut interest rates sharply… The Asian economy was growing full out in 2007. The last thing it needed was lower interest rates. But that's what it got, given the habit of limiting the fluctuation of Asian currencies against the dollar. Allowing Asian interest rates to rise more sharply against US rates would have caused Asian currencies to appreciate against the dollar more strongly. And for all their talk of greater exchange rate flexibility, this was not something that Asian governments and central banks were prepared to countenance. As a result, Asian economies that needed demand restraint got demand stimulus instead.
While this diagnosis is partly true, in fact, the nominal interest rates in most countries did not follow the US's lead. Figure 2 [ PDF 224.6KB | 1 page ] shows the recent changes in the interest rates in selected countries. Except for Hong Kong, China, which adopts a currency board and hence does not have any other option, the nominal interest rates in most other countries either did not change much or increased.7
However, Eichengreen's point that the US is responsible for the recent global high inflation may still be valid if we look back further. Since 1992, when the US experienced a slight surplus in its current account balance, the US current account deficit widened, until recently, when it began to close. However, there are East Asian countries (including the PRC and Japan), EU countries, and oil-producing countries that have experienced a significant current account surplus. This scenario of global imbalance implies that an enormous amount of liquidity has been poured into the global economy. Many countries that are now experiencing a current account surplus, for fear of exchange rate appreciation have chosen to accumulate foreign reserves by intervening in the foreign exchange market. At the same time, in order to avoid large increases in domestic liquidity, these countries sterilized a large fraction of their reserve accumulation. However, this attempt was only partially successful, resulting in domestic liquidity increases. Even though the previously mentioned forces of globalization helped prevent these countries from facing immediate inflation, the pressure toward inflation was hiding in the asset price increases. Hence, eventual inflation was unavoidable.
Interestingly, however, the rising inflation is much more visible in emerging economies. For example, the headline inflation rate in June 2008 is 8.9% in Thailand and over 10% in Indonesia, Philippines, and Viet Nam. In contrast, the headline inflation rate in the US, the source of global liquidity, was 5.0% in the same month.
The reason why emerging economies suffer from more severe inflation is the recent oil and food price increase that is also considered as another culprit of the recent inflation. The WEO Update (2008: 1, 2) argues that “rising energy and commodity prices have boosted inflationary pressure, particularly in emerging and developing economies” and that “the driving force behind higher inflation is higher food and fuel prices.” Because manufacturing sectors have migrated from more advanced countries to emerging countries, emerging countries are suffering from the oil shocks as badly as advanced countries did in the 1970s.
There is also divergence between headline inflation and core inflation. In advanced countries, the headline inflation in May 2008 rose to 3.5%, while core inflation remained at 1.8%. In emerging and developing economies, headline and core inflation rose to 8.6% and 4.2% respectively (WEO 2008). The fact that headline inflation is rising much more rapidly suggests that the recent inflation is associated closely with the recent fuel and food price increases.
B. Policy Responses to High Inflation
The recent oil price increases are also expected to adversely influence the world economy. While there has been no consensus about whether or not the slowdown of the US economy will spill over to other regions, there is no doubt that the oil price shock is global in nature and could therefore potentially affect economies around the world.
The high inflation in emerging Asian economies presents policymakers in the region with a serious dilemma. In order to keep the inflation rate from rising, policymakers have to raise the interest rate. However, the increased interest rate would, in turn, likely slow down the economy.
The fact that a number of emerging Asian countries such as Korea, Thailand, and Indonesia, to name a few, have adopted the inflation targeting regime may or may not complicate the situation. Strict inflation targeting is supposed to imply that the only objective of monetary policy is to maintain low inflation. However, in most countries, the inflation rate has already deviated from the target range for some time and there is no hope that the inflation rate will return to the target range soon. The reason many countries allow the inflation rate to stay out of the target range is because they worry about the possibility of slowdown of their economies. Most economists agree that a central bank that adopts a policy of inflation targeting actually has a dual mandate not just to maintain the inflation rate in the target range but also to foster growth.8
The current situation, however, poses a serious challenge to the central banks of many emerging Asian countries. In most countries, the central banks lack history to build up a reputation as inflation fighters. By adopting inflation targeting, they could enjoy one of the most important virtues of inflation targeting—i.e., that inflation expectation is also anchored in the target range. Currently, they face a real test of their credibility. If the inflation is out of the target range for a long time, the inflation expectation would likewise not remain in the target range. The unanchored inflation expectation would stimulate wage increases, which in turn would lead to another round of price increases. Eventually this adverse price-wage spiral would lead central banks to face the even more painful costs of lowering the inflation rate later.
WEO (2008:1) strongly recommends tightening monetary policy. It also argues that, in order to reverse the recent build-up in inflation, tightened monetary policy should be combined with “greater fiscal restraint and, in some cases, with more flexible exchange rate management.” However, Eichengreen (2008) approaches the problem in a different way. He agrees that the central banks in emerging Asia are left with no alternative but to tighten their monetary policies. The policy package he recommends for these countries is a combination of monetary tightening, currency appreciation, and fiscal stimulus. Compared to the WEO's recommendation, the main difference with Eichengreen's suggestion lies in their respective stances on fiscal policy. Eichengreen (2008) argues that while contractionary monetary policy is unavoidable, “tax cuts and increases in public spending on locally produced goods will limit the contraction of aggregate demand,” and at the same time, by stimulating the demand for locally-produced goods, these fiscal actions will appreciate the exchange rate, which will moderate the rise in import prices and help contain inflationary pressure.
Eichengreen places the PRC at the top of the list of countries that have the ability to respond by expansionary fiscal policy. Especially in the relatively underdeveloped areas, such as the western part of the country, the PRC can still enjoy a high return on additional infrastructure investment. Besides the PRC, Eichengreen named Korea; Malaysia; Singapore; and Taipei,China as candidates to potentially implement more expansionary fiscal policy. However, unlike in the case of the PRC, he argues that the fiscal stimulus in these countries should be explicitly temporary.
Another important question is how helpful the exchange rate appreciation would be in alleviating the inflationary pressure. A number of East Asian countries that have maintained the exchange rate undervalued to promote exports may find that now is the right time to let the exchange rate move more freely in the foreign exchange market so that it can appreciate. The appreciation of the exchange rate, by lowering the price of the imported goods, can actually reduce the inflationary pressure. However, it is important to note that this is not a fundamental solution to inflationary pressure, because the exchange rate cannot continuously appreciate. In essence, exchange rate determines only the relative price between imported goods and domestically produced goods. Eventually the general price level is entirely determined by domestic monetary policy.
Sometimes policymakers consider intervention in the exchange rate as an independent policy option. Korea's central bank's recent action is an example of this usage of exchange rate intervention. Recently, the central bank of Korea actively intervened in the foreign exchange market in the hopes of mitigating inflation pressure. In July 2008, the heavy intervention by the Korea's central bank changed the exchange rate to around 1,000 Korean won per US dollar, which amounts to about a 5% appreciation in one or two days. The question is whether this kind of exchange rate intervention is going to be successful for a country like Korea that has begun to suffer from current account deficits and that has completely open capital markets. As I write this article, the Korean won has depreciated back to 1,136 Korean won per US dollar (or, about 13.6 %) since July.
A number of studies have pointed out that, if the terms of trade aggravate, the exchange rate should be depreciated to rebalance the trade account. The flexible exchange rate will help to lesson the impact of external shocks; if not, the domestic sector should have the burden of adjustment, which would require low income since the demand for imports should be lowered. This domestic adjustment is much more costly for the economy. The oil price increase is, for most countries that rely on imported oil, one of the worst in terms of trade shocks. Hence, in order to rebalance the trade account, it is desirable for the exchange rate to depreciate, rather than to appreciate, against oil-producing countries. Since emerging East Asian economies are more adversely affected by oil price increases than is the US, the exchange rates of these countries should be depreciated more, implying depreciation against the US dollar as well. However the depreciation of the exchange rate will aggravate the inflationary pressure. Certain countries that are suffering from the current account deficits, like Korea, also face this kind of dilemma in dealing with the exchange rate policy.
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