[Opinion] Stagflation and Interest Rate Hikes

The stock market has turned blue, signaling warning lights for our economy. On the 13th, the KOSPI market fell 3.52%, hitting a new yearly low. The KOSDAQ market's decline was even steeper, plummeting 4.72% in just one day. Our stock market, which was struggling to conclude the COVID-19 pandemic situation, now faces another challenging period due to the unfamiliar combination of inflation and economic recession.

The dominant keywords currently controlling the stock market are undoubtedly inflation and recession. Domestic consumer prices in May rose 5.4% compared to the same month last year, marking the largest increase in 14 years. Inflation in the United States is even more severe, with last weekend's reported figure at a staggering 8.6%, the highest in 41 years. Inflation tends not to decrease easily once it rises.

Some in the market are hopeful that the Federal Reserve's aggressive interest rate hikes will soon stabilize inflation. This is an overly complacent view. It is highly likely that inflation will remain at similar levels at least through the third quarter of this year, and only after a prolonged period of aggressive monetary tightening by global central banks will stability be achieved.

If the Fed continues its high-intensity monetary tightening, the possibility of the U.S. and global economies falling into recession is quite high. The Fed raised the benchmark interest rate by 0.5% in May, and it is almost certain that the June FOMC will implement another increase of 0.5% or more. A similar rate hike is expected in July as well. Alongside interest rate hikes, the Fed has accelerated liquidity reduction by initiating quantitative tightening (QT) from June. The pace of monetary tightening is unprecedented, and at this speed, it would be unusual if a recession does not occur.

When inflation and recession combine, stagflation occurs. For the MZ generation, this may be a story heard only in economics lectures, as it happened before they were born, but for older generations, stagflation remains a vivid and nightmarish memory. The first oil shock in October 1973 and the subsequent stagflation, followed by the second oil shock in January 1979 and the double-dip recession from 1980 to 1982, engulfed the global economy. That terrifying stagflation now shows signs of reemerging after more than 40 years.

History is said not to repeat itself in exactly the same way. However, it is hard to deny that the approaching stagflation closely resembles that of 40 years ago. There is a commonality in the long-standing macroeconomic environment vulnerable to inflation. Additionally, the rise in grain prices alongside the oil shocks, and the persistent wage increases despite ongoing recession, are not just a sense of d?j? vu felt by the author alone.

The two economic challenges of inflation and recession are very difficult to solve simultaneously. So, where should the priority lie is clear. When inflation rates are already high, the scope for using economic stimulus measures, including monetary and fiscal policies, is greatly limited. Attempting stimulus measures tends to raise inflation further while having minimal effect on improving the real economy.

It is also important to understand that changing inflation expectations through monetary tightening takes considerable time. Global central banks will diligently apply these lessons learned in the 20th century as monetary policy tools this time as well. The cost of controlling inflation will be greater than expected, and preparing countermeasures to survive the coming ice age is urgently needed.

Hwang Se-woon, Senior Research Fellow, Korea Capital Market Institute