"Expected Inflation-Price Increase Correlation 0.6... High Prices to Persist for the Time Being"

The Bank of Korea: "Clear Positive Correlation Between Expected Inflation and Actual Inflation During Inflationary Periods"

[Asia Economy Reporter Seo So-jeong] As the high inflation rate of 5-6% continues domestically, the rise in economic agents' inflation expectations has raised the possibility that the recent high inflation situation may persist longer than anticipated.

According to the Monetary and Credit Policy Report recently submitted by the Bank of Korea to the National Assembly, expected inflation, which reflects economic agents' forecasts of future price increases, is likely to influence future price trends as it is incorporated into wage and product price decisions.

In South Korea, the general public's expected inflation (over the next year) has steadily increased since last year, reaching a high level of around 4% in the second half of this year. Generally, short-term expected inflation tends to be influenced by the actual inflation at the time expectations are formed, and a positive correlation between expected and actual inflation has been particularly evident during periods of rising prices.

According to the Bank of Korea, the correlation between expected inflation and consumer price inflation was 0.60 during inflationary periods and 0.11 during periods of price deceleration.

In particular, if inflation expectations become unstable, the expectation formation behavior of economic agents may change, potentially increasing the persistence of inflation. The Bank of Korea's macroeconomic model analysis showed that when expectations are unstable, the actual inflation response to economic shocks is larger and lasts longer compared to when expectations are stable.

Furthermore, an analysis using a cross-panel vector autoregression model on data from 33 countries found that when wage growth remains consistently high and inflation expectations become unstable, the interaction between prices and wages intensifies, thereby increasing the persistence of inflation. This is because when expected inflation becomes unstable, companies tend to pass on the cost burden from wage increases to consumer prices.

The Bank of Korea stated, "If the sharp rise in prices continues as seen recently in the UK, and the upward trend in short-term expected inflation persists, long-term expected inflation is also likely to rise significantly." It added, "Since domestic short-term expected inflation remains at a high level of around 4%, continuous policy responses are necessary to stabilize inflation expectations."