[Lee Jong-woo's Economic Reading] Market Overreacts to Inflation... Fed Also Formalizes Rate Hike and Price Increase

Increase in US Household Disposable Income Due to Government Subsidies and Employment Improvement Fuels Inflation Sentiment
Employment Recovery and Raw Material Price Rise May Not Necessarily Cause Inflation
Fed Rate Hike Mentioned, Bank of Korea May Also Raise Rates as Early as Q3

The biggest risk factor for the global economy in the second half of the year is inflation. The U.S. Federal Reserve (Fed) has recently stated that prices will stabilize soon, and even though consumer prices have risen sharply, interest rates are falling, which seems to indicate that the market agrees with the Fed's view. However, anxiety still cannot be completely dispelled.

The inflationary sentiment is driven by consumption. Disposable income for American households has increased due to government support payments and improvements in employment. Although wages fell significantly in the second quarter of last year and have not yet recovered to pre-COVID-19 levels, the actual money available for consumption has increased thanks to government aid. As a result, U.S. consumer spending recovered to pre-COVID levels in January and was 16% higher than last year in May. If production could be increased in line with the rise in consumption, the impact on prices could be minimized, but the situation is unfavorable. Due to supply bottlenecks, it is not possible to secure the necessary amount, and the increase in consumption is leading to higher product prices.

It is true that consumption capacity has increased, but that does not necessarily mean prices will rise proportionally. A significant portion of the government support money has not been used for actual consumption. When the U.S. government issued the first round of support payments in the first half of last year, 74% of the amount was spent on consumption. During the second round of support in the second half, this ratio dropped to 22%, and only 19% of the third round of payments issued this year was used for consumption. Instead, nearly half of the second and third round payments were used to repay debt, and the rest went into savings. As the amount of money going into actual consumption decreases, the likelihood of inflation occurring also weakens. The pattern of fund usage has become entrenched, so it is likely that the current behavior regarding support fund usage will not change going forward. Money saved will be spent over time, reducing its impact on prices. If consumption does not increase as much as expected in the second half, it will be negative for the economy but a favorable outcome for inflation.

Employment will also have a mixed impact on inflation. Until recently, employment was expected to drive prices up. Looking at the historical relationship between the U.S. unemployment rate and wages, once the unemployment rate fell below 5.5%, wage growth accelerated, causing wages to push prices higher. Since the unemployment rate dropped to 5.8% in May, the margin for wage increases is now limited. Considering the additional effect of increased service-related employment due to herd immunity, inflation could worsen in the second half.

However, it should be noted that while employment growth has historically been a factor in inflation, this time the two may be decoupled. The number of permanently unemployed Americans has increased from 1.5 million before COVID-19 to 3.7 million now, indicating a large pool of idle labor. By sector, employment recovery is particularly slow in face-to-face activities such as accommodation, leisure, and education. Compared to January last year, employment among low-wage groups has decreased by 23.6%, while employment among higher-wage groups has actually increased by 5.2%. So far, because the U.S. government has provided subsidies, low-wage workers have had little incentive to find jobs, but the situation will change once subsidies end in September. Low-wage groups tend to have a high propensity to consume but limited cash reserves, so they cannot afford to remain unemployed for long. If they return to work quickly, the labor shortage that would drive wages up will be delayed. The situation is similar for service workers. Travel, leisure, and hotel industries have been in recession for over a year, so these companies are not in a position to raise wages. Considering these factors, employment recovery may not necessarily trigger inflation.

Finally, raw material prices must be considered. Following Brent crude, West Texas Intermediate (WTI) prices have also exceeded $70 per barrel. Prices of natural resources such as copper, as well as agricultural products like corn and wheat, have risen more than 50% compared to the beginning of the year. When oil prices surpassed $70, forecasts emerged that prices could exceed $100 within the year, but this is unlikely. Higher prices lead to increased raw material supply. Before COVID-19, 800 companies in the U.S. produced shale oil. Due to the pandemic and falling oil prices, this number dropped sharply to 300 at one point but has since risen to about 400. Still, this is only about half of the pre-pandemic level, and considering the recent surge in oil prices, the number of producers is expected to continue increasing. The situation is similar for other raw materials. Copper production in South America, which was halted due to COVID-19, is resuming as vaccination reduces the risk of disease.

Since the inflation base effect peaked in the second quarter, prices in the second half are expected to be lower than in the first half just from this effect alone. Structural changes toward online consumption during the COVID-19 pandemic also help curb price increases. Considering these various factors, it seems the market may be overreacting to inflation. Nevertheless, inflation rates higher than usual cannot be avoided for the next one to two years because many factors that can drive prices up have increased during the COVID-19 experience.

Perhaps influenced by this assessment, the Fed has changed its stance from not raising interest rates until 2023 to indicating it may raise rates twice. It announced an inflation forecast of 3.4% for this year, officially acknowledging inflation in the 3% range. This is a step back from the earlier view that inflation was temporary and conditions would improve in the second half, aligning with market expectations. How many times and when interest rates will be raised depends on inflation. If prices do not rise significantly in the second half, the Fed will likely maintain its stance of not touching rates, but if inflation surges, it will have no choice but to raise rates even next year. Since the Fed has mentioned the possibility of rate hikes, previous plans regarding interest rates have become meaningless.

The Fed's mention of rate hikes has eased the burden on the Bank of Korea. When the possibility of a rate increase was first mentioned in May, Korea faced the burden of raising rates alone, but now it can choose freely. It is expected that the Bank of Korea will begin raising rates as early as the third quarter or by the end of the year at the latest. While inflation will be the main factor determining the timing of rate hikes, real estate prices are also likely to be considered, as rate hikes are a powerful tool to control real estate prices.