Price pressure: Core prices may continue to rise as Asian exports plunge in June

Not pretty. One weak payroll number may be shrugged off with an extra dose of faith. But a second one, when things are already on a knife's edge, requires a much more sober assessment. Asia, for all the chatter about decoupling - and, yes, we are cheerleaders, too - can't drive the world on its own.

Exports will struggle. Forget the Japanese supply crunch, this thing strikes much deeper than that. With domestic demand robust in much of the region, monetary tightening will still proceed, even if cautiously. But, on balance, officials may become more protective of exchange rates.

We'll spare you the details of Friday's labor report. The headlines were loud enough. The summer patch is now looking a bit too patchy for our taste. Asia will feel the chill mostly through exports. In fact, we've recently highlighted that export order growth has continued to slow across the region in June.

Shipments from Taiwan, in fact, plunged during the month. Sure, they held up better in Korea, especially if you strip out some bulky items like vessels, but the overall picture isn't terribly reassuring. The fading Japanese supply crunch will add some juice in July, and the country is also importing more and more from the rest of the region as rebuilding kicks in. But, clearly, tumbling demand in the West could kill the expected bounce.

Let's think through some of the implications. If exports continue to sputter through the third quarter, policy-makers in the region will adopt a more defensive stance. Obviously, their task is not to be envied. While headline inflation is rolling over, core price pressures remain elevated, and are in most cases still accelerating.

This, as we have long argued, is not simply a lagged effect of rising food and oil prices earlier this year, but reflects an underlying deterioration in the trade-off between inflation and growth in the region. More simply: Asia is gradually running out of excess capacity to meet rampant local demand. That process continues, even if second quarter growth slowed. From this perspective, there is clearly a need to raise rates further.

On the other hand, exports are important, not just economically, but also politically. So, as shipments slow, and the grumblings become louder, officials will turn more protective. Therefore, from a macro perspective, a weaker payrolls number, and the attendant concerns over demand in the West, should make policy-makers less tolerant of exchange rate appreciation.

At the same time, relatively robust local demand, and frothy asset prices to boot, may require a further adjustment of interest rates, even if gradually, and the imposition of various regulatory restrictions.

Of course, if the world collapses around Asia, interest rate hikes are off the table, since at this point a crash in exports would knock out local demand as well. But, we are not quite at that stage yet. Our colleagues in the Old and New World maintain still positive growth forecasts for the second half of the year, with an ultimately faster pace of expansion, in fact, than during the first six months of 2011.

Rather, our argument is more nuanced: the weak payrolls number, for now, implies stagnating external demand that will persist beyond the end of Japanese supply chain disruptions. This, at the margin, should make officials more cautious about using exchange rate appreciation as a tool for monetary tightening.

In fact, in recent weeks we were struck by how many investors claimed to detect a shift in preference among central bankers away from interest rate hikes towards the use of exchange rate appreciation to temper local price pressures.

Take Korea. Here, inflation remains uncomfortably sticky. We are therefore expecting another two interest rate hikes this year. The view that the Bank of Korea may use exchange rate appreciation instead, and forego rate tweaks altogether, appears misplaced.

This is all the more so given that the pass-through from exchange rate movements to local inflation is generally fairly small. In addition, weaker demand in the West implies lower commodity prices - just take a look at what oil prices did on Friday - which further reduces the usefulness of exchange rate appreciation in the battle against inflation.

There are exceptions, of course. Not all economies in Asia boast a large export sector that calls for, quite literally, prudent exchange rate management. In Indonesia, for example, there is evidence that the central bank may have turned more tolerant of appreciation, possibly substituting exchange rate movements for interest rate changes. But, even here, the argument only carries so far.

Fundamentally, price pressures in Indonesia, as elsewhere in Asia, are driven by local demand, with exchange rate swings having relatively little impact on inflation readings, especially at the core level where now the problem lies. Therefore, our chief Indonesia economist, Wellian Wiranto, is still expecting Bank Indonesia to raise rates this year.

In fact, we expect interest rate hikes over the second half of this year in every single regional economy, with the exception of Japan and China. The former, obviously, ticks to another rhythm. The latter will use reserve ratio requirement hikes instead.