Asia is particularly vulnerable because it sits at the center of global manufacturing and technology supply chains while remaining heavily reliant on imported energy
Asia’s central banks face mounting pressure to tighten monetary policy as the region finds itself caught between an energy crunch and an AI boom, a combination that threatens to keep inflation elevated.
Asia is particularly vulnerable because it sits at the center of global manufacturing and technology supply chains while remaining heavily reliant on imported energy. That leaves policymakers confronting a rare mix of cost-push and demand-driven inflation pressures.
The twin forces are bolstering the case for higher interest rates. India and Japan may raise borrowing costs this month, with South Korea seen following in July. Indonesia and Sri Lanka have already delivered jumbo hikes, while Australia has raised rates three times this year.
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After months of assessing the economic fallout from the Iran war from the sidelines, policymakers are shifting to inflation-fighting mode as uncertainty over the conflict’s resolution raises the prospect of persistently higher fuel costs across Asia, the region most reliant on supplies passing through the Strait of Hormuz.
At the same time, global appetite for artificial intelligence has ramped up this year, spurring economic activity that threatens to spill over to consumer prices in the chip-manufacturing giants of developed Asia.
“These forces cannot be viewed in isolation,” said Jerome Tay, senior portfolio manager of fixed income at Aberdeen Group Plc. “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 reflecting those concerns. Government bond yields have risen across the region as traders price in a greater risk of policy tightening, while currencies in energy-importing economies such as the Philippine peso and Indonesian rupiah have weakened on concerns that higher fuel costs will fan inflation and strain external balances.
The Bank of Japan is widely expected to raise its benchmark interest rate at its meeting in mid-June to the highest level since 1995. Elevated oil prices, coupled with a weak yen, are posing upside risks to consumer prices, even as utility and gasoline subsidies have so far kept a lid on the flow through to consumer prices.
Five of the nine BOJ board members have recently signaled support for further policy normalization, giving Governor Kazuo Ueda a majority should he decide to push ahead with raising Japan’s rates, which sit at the lowest level among major economies.
Meanwhile, the Bank of Korea delivered one of its strongest hawkish signals in years even as it held the policy rate last week, with two policymakers dissenting in favor of a hike and the six-month dot plot shifting sharply higher.
South Korea’s economy and exports continue to outperform expectations due to the AI boom. Inflation has overshot expectations, with eye-popping AI bonuses set to add to price pressures created by costlier oil and the weaker won.
Chasing Rabbits
Governor Shin Hyun Song said last week that central bankers struggle when they are “chasing two rabbits — or even three rabbits — at once,” but this time inflation, growth, the exchange rate and housing-related financial risks are all pointing in 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, senior investment strategist for Asia at Amundi Investment Institute. “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 even more complex for developing Asia, which isn’t getting the AI-demand bump and instead has seen the energy crisis pull growth and inflation in opposite directions. That’s left currencies such as Indonesia’s rupiah and India’s rupee languishing near record low levels — further pressuring central bankers to act.
Analysts are still split over whether the Reserve Bank of India will tighten on Friday as higher borrowing costs could choke an economy that’s already seeing softer growth. Others argue that tightening is needed to get ahead of inflation after a series of fuel price hikes, and to support the rupee, which has slumped more than 5% this year.
“Rising inflationary pressures have reduced the scope for policymakers to remain on the sidelines,” said Capital Economics’ deputy chief emerging markets economist Shilan Shah. “But the main motivation for tightening will be mounting concern over the weakness of the rupee.”
The region’s biggest economy, China, is emerging from years of deflation, with solid exports and the tech boom supporting the outlook. But with domestic demand still weak, authorities last month let the interest rate on a one-year policy loan to banks decline to a record low, a sign Beijing is stepping up support as the economy loses momentum.
Like many of their Asian peers, major developed-world central banks including the Federal Reserve and the Bank of England have so far responded cautiously to the energy shock, choosing to keep interest rates unchanged in recent meetings as they assess whether higher oil prices will feed into broader inflation pressures.
But there’s increasing expectation some will be forced to act. The European Central Bank is likely to raise rates next week for the first time since 2023. For the BOE, markets expect one quarter-point increase by the end of 2026 as a resurgence in inflation forces the central bank to shelve plans to reduce rates further this year.
Investors are betting there’s a roughly one-in-four chance the Fed will raise rates by year’s end, according to pricing in futures contracts. The Fed’s next policy meeting takes place June 17-18, the first gathering led by new Fed Chairman Kevin Warsh.
The current outlook varies from the inflation breakout that followed the pandemic. Rather than a synchronized global shock, the rise in energy prices is exposing deep differences in countries’ economic structures, creating a more uneven landscape for growth, inflation and monetary policy, according to 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 prefers India, Indonesia and South Korea and is more cautious on China, Thailand and the Philippines.
