[Insight & Opinion] New Government Economic Team Must Become "Inflation Fighters"

Urgent Need for Active Measures to Curb Inflation
Amid Soaring Prices Driven by Global Uncertainty

Kim Jeong-sik, Professor Emeritus, Department of Economics, Yonsei University

Prices are rising sharply. With the prices of flour as well as cooking oil increasing, the rise in living costs is expected to make life even more difficult for ordinary people. The background to the rising prices is primarily the Russia-Ukraine war, which has significantly increased the prices of crude oil, raw materials, and grains. Additionally, the US interest rate hikes have pushed up the exchange rate, causing import prices to soar. As the COVID-19 situation gradually stabilizes, the liquidity released into the market has increased demand, which is also a cause. The combination of rising costs and demand driving prices up is causing a significant increase in prices. The problem is that when costs rise as they are now, it is difficult to control inflation. The government urgently needs to prepare active measures to curb inflation.

First, the Bank of Korea must raise interest rates sharply to lower inflation expectations. Inflation triggers wage increases, which in turn raise inflation again, creating a wage-inflation vicious cycle that drags the economy down. To prevent the economy from falling into this vicious cycle and stabilize prices, it is important to lower inflation expectations. This stabilizes wages and helps the economy escape stagflation. To this end, the Bank of Korea must gain the trust of the public as an inflation fighter, like the US Federal Reserve (Fed). Even if it means accepting an economic downturn, it must show its determination to raise interest rates to control inflation.

Stabilizing the exchange rate to reduce import prices is also important. With the US interest rate hikes and worsening trade balance, the exchange rate is rising sharply, approaching 1,300 won. To stabilize import prices, it is necessary to prevent a sudden surge in the exchange rate in the foreign exchange market, which requires increasing exports to maintain a trade surplus. When external credibility is maintained and capital outflows caused by US interest rate hikes are reduced, the exchange rate can stabilize. Strengthening cooperation with the US to resume the Korea-US currency swap, which ended at the end of last year, is another method. If a safety net for foreign exchange supply is established through the currency swap, the foreign exchange market can regain stability.

Fiscal inflation must also be guarded against. If stagflation deepens the economic downturn, fiscal spending may increase, leading to an increase in market liquidity through government bond issuance. Inflation can rise due to fiscal policy. In fact, fiscal spending has increased significantly this year through supplementary budgets. The first supplementary budget released 17 trillion won in February, and before the upcoming local elections, nearly 60 trillion won is expected to be released through supplementary budgets including support for small business owners. As the second half of the year approaches, with US interest rate hikes and rising raw material prices expected to deepen the economic downturn, a third supplementary budget cannot be ruled out. Ultimately, as market liquidity increases through government bond issuance, the Bank of Korea may fail to stabilize prices due to fiscal inflation. The government must streamline fiscal spending to prevent fiscal inflation.

The Yoon Seok-yeol administration has faced a perfect storm crisis since its inception. Inflation is rising due to increases in crude oil and raw material prices, and the exchange rate is rising due to US interest rate hikes, increasing the risk of capital outflows. Increased household debt, national debt, and the real estate bubble also complicate economic policy management. While the continued trade deficit caused by rising crude oil prices is a problem, there are concerns that the trade deficit will expand due to reduced exports to China following the Korea-US economic security alliance. To lower rising inflation and prevent the economy from facing a crisis, the new government's economic team’s correct policy choices and active measures are more important than ever.