[Insight & Opinion] The Cost of High Interest Rates: Concerns Over Economic Recession

As the exchange rate rises, concerns about the recurrence of inflation are growing. Inflation causes great hardship to the public not only through rising prices but also through economic recession caused by interest rate hikes. Policy authorities need to carefully manage inflation measures to prevent the economic downturn from worsening due to high interest rates.

First, the cost of high interest rates, which is economic recession, must be guarded against. To lower inflation, central banks prefer significant interest rate hikes, but the government and political circles must also consider the economic recession. Even if prices rise, people can still manage, but if the economy contracts, causing businesses to fail and jobs to be lost, life becomes difficult. High interest rates and economic recession also reduce support for the government, leading to policy failure. Policy authorities should raise interest rates within a range that does not excessively depress the economy, rather than focusing solely on price stability through high interest rates.

This is well illustrated by past government cases. In the early 1980s, Paul Volcker, chairman of the U.S. Federal Reserve, raised interest rates sharply to curb inflation caused by rising oil prices, successfully controlling inflation but causing severe economic recession and increasing business failures. At that time, U.S. President Jimmy Carter failed to win re-election. In South Korea, the Roh Moo-hyun administration, which sharply raised interest rates in a short period to curb real estate prices and inflation, faced difficulties as public dissatisfaction with the economic recession grew. Similarly, the Yoon Suk-yeol administration’s use of high interest rate policies led to failure in the general election, resulting in a minority government and delays in pushing forward four major reforms.

Next, it is important to establish countermeasures considering the causes of inflation. Inflation causes include demand-pull and cost-push types. Demand-pull inflation occurs when the economy is booming and demand increases, raising prices; raising interest rates to reduce consumption and investment demand can stabilize prices. On the other hand, cost-push inflation occurs when costs rise, pushing prices up, and it is not easy to lower inflation by raising interest rates. Prices can only stabilize if the causes?oil prices, exchange rates, and wages?fall. In the case of cost-push inflation, controlling prices through interest rate hikes requires significant increases and entails the cost of severe economic recession, including business failures. Policy authorities should be cautious about excessive interest rate hikes in the case of cost-push inflation.

Since 2022, both South Korea and the United States have experienced high inflation. However, the causes of price increases in the two countries differ. The U.S. inflation was demand-pull, caused by increased demand due to economic boom, while South Korea’s inflation was cost-push, with the economy in recession but inflation rising due to higher oil prices and exchange rates. The recent decline in inflation is also attributed to the fall in exchange rates and oil prices. From this perspective, it is appropriate for the U.S. to respond with interest rate hikes, but if South Korea raises interest rates to respond, it will suffer severe domestic economic recession and increased public hardship, as is happening now.

Finally, complementary policies are needed to prevent a hard landing of the economy when raising interest rates. The U.S. prevented a hard landing by sharply raising interest rates in response to inflation while increasing fiscal spending and expanding the money supply. However, South Korea, despite having cost-push inflation, sharply raised interest rates, tightened loan regulations, and adopted a tightening policy mix that reduced fiscal spending. This is the background for the deepening domestic economic recession. A hard landing of the economy cannot be ignored as it increases financial insolvency and greatly raises the risk of asset price bubble collapse.

High interest rate policies can cause a hard landing, trigger a financial crisis, and reduce support for the government. In establishing inflation measures, the Bank of Korea needs to consider the causes of price increases, and policy authorities need to formulate measures considering the economic recession.

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