[Insight & Opinion] Different from the US... Export and Domestic Demand Boost Needed over Interest Rate Hikes

The biggest economic issue this year is the US interest rate hike. Recently, as inflation is expected not to decrease quickly, attention is focused on how high US interest rates will rise and how Korean policymakers should respond.

First, the US interest rate hike is likely to be higher than expected and the high interest rates may persist for a long time. This is because the current inflation is cost-push inflation. Inflation caused by increased demand can be easily resolved by raising interest rates to reduce consumption and investment. However, in the case of cost-push inflation, the increased production costs cannot be directly lowered, so the economy is depressed to reduce demand or inflation expectations are lowered to suppress wage increases, indirectly lowering prices. Therefore, a large interest rate hike is necessary, which causes serious side effects such as economic recession and corporate bankruptcies.

Another reason is that wages have risen due to a shortage of labor supply in the US. Since labor supply cannot be increased in the short term, inflation is likely to persist. Additionally, there is a time lag of more than a year for the impact of interest rate hikes on the economy and prices. Considering this, it is difficult to lower US inflation in the short term, and it is likely that high interest rates will continue until the first half of next year along with a large interest rate hike.

How should Korea respond to the US interest rate hike? The Bank of Korea faces a choice between raising interest rates sharply to reduce the interest rate gap with the US or responding with minimal rate hikes considering the domestic economic recession. However, caution is needed with large interest rate hikes. This is because reducing the interest rate gap does not necessarily prevent capital outflows, and capital outflows may increase due to domestic economic recession. Asian countries, including Korea, are under different conditions than the US.

The US can raise interest rates because the economy is booming, but Asian countries including Korea cannot. If interest rates are raised further during an economic recession, companies and self-employed businesses that survived the COVID-19 period may collapse due to high interest rates. Large interest rate hikes can increase corporate bankruptcies, burst real estate bubbles, encourage capital outflows, and further raise exchange rates. In fact, inflation in Asian countries is around 5%, similar to Korea, but benchmark interest rates are maintained at lower levels such as 2.75% in Malaysia and 1.5% in Thailand compared to Korea’s 3.5%.

To respond to the US interest rate hike without sharply raising interest rates, the domestic economy must be stabilized. To do this, exports should be increased to maintain a current account surplus trend and the economy and real estate prices should be smoothly adjusted. To increase exports, export companies should be invited to the export strategy meeting chaired by the president to develop new export markets. Fiscal spending should be increased to support low-income groups, and investment in transportation and education infrastructure in low-income residential areas should be increased to stimulate the construction industry, which has strong ripple effects. To stabilize real estate prices, various regulations and tax policies from the low-interest era should be significantly eased to suit the high-interest environment. This will stimulate domestic demand and prevent capital outflows caused by economic recession.

Unlike the US, which is experiencing inflation due to rising wages, Korea is experiencing inflation due to high international oil and raw material prices. As energy prices fall due to the global economic recession, Korean inflation is gradually stabilizing and is expected to decrease further if exchange rates and public utility charges stabilize. Policymakers should focus on boosting exports and domestic demand rather than large interest rate hikes with many side effects to respond to the US interest rate hike.

Jungsik Kim, Professor Emeritus, Department of Economics, Yonsei University