Inflation has been dormant for a long period of time, but it may start to erupt soon.
Since the Asian crisis ten years ago, overall CPI inflation has generally been dormant, but this has masked an increasingly fierce tug-of-war between inflationary forces and those that suppress inflation. The recent decline in global capital markets has increased the uncertainty facing the global economic outlook, but if global growth remains robust, we believe the risk of inflationary forces beginning to dominate is growing.
Currently, there are three inflationary forces at play in Asia that have been strengthening and, if global growth remains strong, could continue to grow:
The disappearance of excess capacity: The Asian crisis caused a severe recession in the region's economy, and the collapse of the IT industry and the spread of the SARS disease in 2003 made the recovery of 1999-2000 short-lived. Affected by the cyclical ups and downs, we estimate that the total economic output of the region has not fully returned to its potential level, with a negative output gap from 1998 to 2005. However, in the past three years, the overall GDP growth rate in Asia (excluding Japan) has exceeded 8%, and we estimate that this has turned the output gap positive for the first time since the Asian crisis in 2006. If the economies in the region continue to grow strongly (we expect the overall growth rate this year to reach 8.2% and 8.3% next year), the output gap in 2008 may rise to +4.6%, the highest in 24 years.
Excess liquidity: Huge current account surpluses and large inflows of capital are putting upward pressure on Asian currencies (requiring appreciation beyond what most central banks are willing to accept). This has made some central banks reluctant to raise interest rates significantly; and most central banks have intervened heavily in the foreign exchange market, leading to rapid growth in base money in certain countries. Broad money supply growth rates in most countries have now reached double digits, and asset markets in various places in the region (such as Shenzhen, Singapore, and Mumbai) appear to have bubbles.
High raw material prices: Oil prices are again approaching historic highs, and our chief energy economist, Ed Morse, now forecasts oil prices to be around $75 per barrel for the rest of this year and next year. If this forecast is correct, base effects (a significant drop in oil prices in the second half of 2006) may soon make oil prices have a significant impact on import price inflation in Asia. Food prices are also rising rapidly, possibly partly due to structural factors (such as greater demand for biofuels and more diversified diets among people in developing countries), which aligns with income growth. Unlike oil, the supply response for food is larger, but it may take some time.