Why the growth-inflation trade-off is lower than you think

INVESTORS are still intensely focused on inflation. The debate is now centred around 2 issues: how sticky inflation will be, and how much central banks need to tighten monetary policy to bring inflation back under control.

Some investors argue that inflation will remain at higher levels for some time and hence central banks need to take policy rates into deeply restrictive territory, even if it means that growth will decelerate meaningfully below trend.

We, however, argue that the sacrifice ratio (the amount of growth sacrifice needed to bring inflation down) is not as high as many think. We think the threshold of interest rates needed to bring inflation under control is lower than what is perceived to be the case.

At the outset, we note that the inflationary pressures Asia is facing are more moderate, as compared to what we are seeing in US, Europe and other emerging markets. Moreover, we expect inflation in the region to peak in this quarter and see downside risks to inflation in the coming months.

We cite 4 factors:

First, Asia’s inflation has had more of a cost-push element to it. The rise in Asia’s headline inflation has been driven by stronger contributions from food, fuel and core-goods inflation. Commodity prices initially rose in response to the outsized rise in goods demand and were then exacerbated by supply shocks amid geopolitical tensions. But since their March peak, they have now fallen by 25 to 40 per cent. Similarly, global food prices, which account for 30 per cent of Asia’s CPI basket, have also fallen significantly from earlier peak levels.

Second, Asian economies are still in the mid-cycle stage of expansion. Unlike the US, we think the policy stimulus enacted in Asia in response to the pandemic was not as outsized. The gross domestic product (GDP) in most of the economies in Asia remain below their pre-Covid path, with the exception of Taiwan. Moreover, Asia’s recovery was, until early this year, supported by the key drivers of exports and capex, with consumption hampered by continued Covid restrictions. This backdrop has limited the strength of the inflationary dynamics.

Third, core-goods inflation in Asia has now peaked. Demand-supply balances are being restored. This is best observed in the global PMI data, where inventory has now surpassed new orders for the second consecutive month. Specifically for the US, where this dynamic was the most pronounced, real goods spending has also declined by 6 per cent from its March 2021 peak, after having risen by 20 per cent in the preceding 14 months. Supply chain disruptions have also eased, reflected in an improvement in supplier delivery times. Moreover, the outsized rise in goods demand had played a role in lifting industrial commodity prices and this is reversing rapidly now. As goods prices are global in nature, this backdrop has meant that Asia core-goods inflation has also peaked.

Fourth, labour market conditions are not that tight in Asia, and we have yet to see adverse signs that higher inflation expectations are translating into stronger demands for wage gains. This is pertinent because if labour markets are tight and wage growth strong, central banks would have a more difficult task in bringing down inflation, but this clearly is not the case for most of Asia.

As it is, nominal wage growth is still running close to or below pre-Covid trends for 92 per cent of the region. The exceptions are Singapore and, to a smaller extent, Australia, followed by Korea. In these areas, labour markets have tightened, with unemployment rates moving lower, and with wage growth above pre-Covid trends in Singapore and broadly in line for Australia and Korea.

Recent developments provide a timely reminder that not all of the inflation is due to strong aggregate demand, and not all of it can be attributed to the tight labour market. We expect inflation to begin its descent back towards central banks’ comfort zones. By Q2 2023, we forecast that 85 per cent of the region in purchasing-power-parity-weighted GDP terms will have inflation within their respective central bank’s comfort zone.

Against this backdrop, we think that monetary policy does not need to enter into deep restrictive territory in the region. The resulting slowdown in domestic demand, especially as it relates to rate-sensitive sectors, should be at a more manageable pace.

Moreover, the relatively healthy state of private sector balance sheets also means that rising rates and slowing growth is unlikely to bring the added tightening in financial conditions as one would expect in a typical late-cycle stage. These factors combined should help ensure that the growth slowdown will be more muted in Asia than is widely perceived. We expect Asia’s GDP growth to improve to 5.2 per cent in 2023 versus 4 per cent in 2022.

The writer is chief Asia economist at Morgan Stanley.