Economies of Asia, including India, have witnessed strong growth and low inflation. While headline inflation was lowered by relatively low commodity prices, core inflation remained moderate despite strong demand conditions.
But why has inflation been so low? And how long will it last?
The International Monetary Fund in its most recent regional economic outlook report tries to understand the dynamics in Asia and derives lessons for policymakers.
Here are some key takeaways from the IMF study.
Is the recent low inflation driven by temporary factors?
The IMF study finds that weaker import prices, including low commodity prices, contributed to half of the undershooting of inflation targets in advanced Asia and most of the undershooting in emerging Asia in recent years.
In addition, China seems to have played an important role in driving both global and regional inflation.
An analysis looking at temporary and trend components suggests that temporary shocks have accounted for bulk of the recent reduction in inflation.
Inflation expectations vs past inflation. What impacts the inflation process more?
While inflation expectations are generally relatively well anchored, especially in advanced Asia and in economies with inflation targeting frameworks, the importance of expectations in driving inflation has declined in recent years with past inflation playing a larger role.
Has the sensitivity of inflation to the unemployment gap declined?
There seems to be a flattening of the Phillips curve compared to the 1990s in advanced Asia and a similar but more continuous flattening in emerging Asia. Outside of Asia, the slope of the Phillips curve seems to have been more stable.
This suggests that inflation has become less sensitive to the unemployment gap.
In Asia, these appears to be a link between the flattening of the Phillips curve and automation (in advanced economies) and between inflation and integration in global value chains. To the extent that automation substitutes, or threatens to substitute, for some low- or middle-skilled workers with routine job tasks, it could weaken the power of such workers to bid up their wages.
Lessons For Policymakers
Through its analysis, the IMF found that inflation could rise in Asia as commodity prices and other temporary factors reverse themselves. Higher inflation in the rest of the world and weaker currencies in the region could pose upside risks, said the report.
In light of its findings, the IMF suggests:
- Central banks should be vigilant in responding to early signs of inflationary pressure, including from global factors.
- A sudden increase in inflation may persist and disinflating may be costly if sensitivity of inflation to the unemployment gap has declined.
- To mitigate the role of imported inflation, exchange rates should be allowed to adjust more flexibly.
- In principle, the monetary policy response to commodity price shocks should be to accommodate first-round effects but not the second-round effects.