Asia Faces Rate Hikes as AI Boom Fuels Inflation
Asia’s central banks are under increasing pressure to tighten monetary policy as the region navigates the challenges posed by an energy crunch alongside an AI boom, a situation that risks sustaining elevated inflation levels. Asia is especially susceptible as it occupies a central position in global manufacturing and technology supply chains, all the while being significantly dependent on imported energy. That presents policymakers with a unique combination of cost-push and demand-driven inflation pressures. The twin forces are strengthening the argument for elevated interest rates. India and Japan may increase borrowing costs this month, with South Korea expected to follow suit in July. Indonesia and Sri Lanka have already implemented significant increases, while Australia has raised rates three times this year. After months of evaluating the economic repercussions of the Iran war from a distance, policymakers are transitioning to a focus on combating inflation as uncertainty surrounding the conflict’s resolution heightens the likelihood of enduringly elevated fuel prices throughout Asia, the area most dependent on supplies traversing the Strait of Hormuz. Simultaneously, the global demand for artificial intelligence has surged this year, driving economic activity that risks impacting consumer prices in the chip-manufacturing powerhouses of developed Asia. “These forces cannot be viewed in isolation,” said Jerome Tay. “AI is driving a positive demand shock, while energy is creating a cost-push inflation impulse. As a result, inflation may remain persistent rather than transitory.”
Markets are already showing signs of those concerns. Government bond yields have increased throughout the region as traders anticipate a heightened risk of policy tightening. Meanwhile, currencies in energy-importing economies, including the Philippine peso and Indonesian rupiah, have depreciated due to worries that rising fuel costs will exacerbate inflation and pressure external balances. The Bank of Japan is widely anticipated to increase its benchmark interest rate at its meeting in mid-June, reaching the highest level since 1995. Rising oil prices, alongside a depreciating yen, present potential upward pressures on consumer prices, despite utility and petrol subsidies currently mitigating their impact on consumer costs. Five of the nine BOJ board members have recently indicated their support for further policy normalisation, providing Governor Kazuo Ueda with a majority if he chooses to proceed with raising Japan’s rates, which currently stand at the lowest level among major economies. Meanwhile, the Bank of Korea issued one of its most pronounced hawkish signals in years, despite maintaining the policy rate last week. Two policymakers expressed dissent in favour of a hike, and the six-month dot plot experienced a significant upward shift. South Korea’s economy and exports are exceeding expectations, driven by the surge in AI technology. Inflation has exceeded expectations, with striking AI bonuses poised to contribute to the price pressures stemming from more expensive oil and a depreciated won.
Governor Shin Hyun Song remarked last week that central bankers face challenges when they are “chasing two rabbits — or even three rabbits — at once.” However, he noted that currently, inflation, growth, the exchange rate, and housing-related financial risks are all aligning towards the same policy direction. “While AI should be disinflationary in the long run, it has led to cost concerns in the near term,” said Aidan Yao. “Everything on the AI supply chain like chips, memories, software, power supply — everything it touches sees prices going higher,” Yao said. The policy calculus is particularly intricate for developing Asia, which is not experiencing the AI-demand boost and has instead witnessed the energy crisis pulling growth and inflation in contrasting directions. That has left currencies such as Indonesia’s rupiah and India’s rupee languishing near record low levels, further pressuring central bankers to act. Analysts remain divided on the likelihood of the Reserve Bank of India implementing a tightening measure on Friday, as increased borrowing costs may hinder an economy that is already experiencing subdued growth. Some contend that tightening measures are necessary to stay ahead of inflation following a series of fuel price increases, as well as to bolster the rupee, which has depreciated over 5% this year. Rising inflationary pressures have reduced the scope for policymakers to remain on the sidelines’, said Shilan Shah. “But the primary impetus for tightening will be growing apprehension regarding the fragility of the rupee.”
The region’s largest economy, China, is emerging from years of deflation, bolstered by robust exports and a thriving tech sector that enhances the outlook. However, with domestic demand remaining weak, authorities last month allowed the interest rate on a one-year policy loan to banks to fall to a record low, indicating that Beijing is intensifying its support as the economy loses momentum. Like many of their Asian counterparts, major developed-world central banks, including the Federal Reserve and the Bank of England, have responded with caution to the energy shock. They have opted to maintain unchanged interest rates in recent meetings while evaluating whether rising oil prices will contribute to wider inflationary pressures. However, there is a growing anticipation that some will be compelled to take action. The European Central Bank is expected to increase rates next week for the first time since 2023. For the BOE, markets anticipate a single quarter-point increase by the end of 2026, as a resurgence in inflation compels the central bank to postpone plans to lower rates further this year.
Investors are anticipating a roughly one-in-four chance that the Fed will raise rates by the end of the year, as indicated by pricing in futures contracts. The Fed’s next policy meeting is scheduled for June 17-18, marking the inaugural gathering under the leadership of new Fed Chairman Kevin Warsh. The current outlook differs significantly from the inflation breakout that ensued after the pandemic. Instead of a synchronised global shock, the increase in energy prices is revealing significant disparities in the economic structures of various countries, resulting in a more uneven environment for growth, inflation, and monetary policy, as stated by Richard Rauch, senior client portfolio manager at Franklin Templeton Fixed Income. “Inflation risks in Asia are more idiosyncratic than in developed markets,” Rauch said, adding that the current environment is creating “greater dispersion.” He shows a preference for India, Indonesia, and South Korea, while exercising more caution regarding China, Thailand, and the Philippines.
