[Insight & Opinion] How to Escape the Trap of Stagflation

Due to the United States' tariff policy, not only the global economy but also the South Korean economy is expected to fall into the trap of stagflation. Economic recession typically reduces demand and lowers prices. However, when supply shocks occur?such as increases in the costs of crude oil, raw materials, wages, and exchange rates?stagflation can arise, where prices rise despite the economic downturn. The Donald Trump administration in the United States is raising tariffs in an effort to reduce the trade deficit. The imposition of tariffs and trade restrictions on China increases import prices and transportation costs, which in turn raises prices and slows economic growth by reducing exports. This has led to concerns about stagflation.

In particular, South Korea has been suffering from a severe domestic recession due to a prolonged high interest rate policy, and upward pressure on prices is building due to the rising exchange rate. If the Trump administration's tariff policy is added to this, the slowdown in growth and inflation are expected to worsen further. There are concerns that the spread of corporate bankruptcies and financial instability will intensify. In fact, due to a decline in exports, South Korea's growth rate in the first quarter has already contracted by -0.2%. The International Monetary Fund (IMF) has also revised its growth forecast for this year from the previous 2% down to 1%. As previously subdued prices are now expected to rise, inflation expectations are also increasing. It is urgent for policymakers to devise measures to escape from stagflation.

First, it is necessary to revive the domestic economy to prevent the spread of corporate bankruptcies and financial instability. This is because the shock from declining exports must be absorbed through domestic demand stimulation to prevent an excessive drop in the growth rate. To stimulate domestic demand, a supplementary budget that increases fiscal spending is needed. Recently, the National Assembly passed a supplementary budget of 13.8 trillion won, but to restore the depressed domestic economy, a second supplementary budget should be considered in the second half of the year. Although fiscal soundness may deteriorate, it is more important to temporarily expand fiscal spending to mitigate the shock of slower growth caused by the US tariff policy.

A low interest rate policy through interest rate cuts is also necessary. In response to the US tariff policy, major economies around the world are expected to adopt low interest rate policies. Low interest rates reduce the burden of interest payments, thereby increasing the capacity for consumption and investment. In addition, it can prevent excessive depreciation of the currency, which can help counteract the decline in exports and the slowdown in growth caused by the US tariff policy. The United States is also pursuing cooperation to appreciate the currencies of countries with trade surpluses against the US, in addition to its tariff policy. This is to prevent the effect of tariffs from being offset by lower import prices in the US if its trading partners raise their exchange rates. However, excessive combinations of low interest rates and low exchange rates should also be avoided, as they can create asset bubbles and lead to a repeat of Japan's bubble collapse and prolonged stagnation.

To lower inflation, it is necessary to stabilize the exchange rate and curb increases in electricity, gas, and other public utility fees to prevent prices from rising. All living costs, including restaurant prices and agricultural product prices, are closely linked to energy costs such as electricity and gas. It is also important to ease non-tariff barriers on agricultural and livestock products to increase imports and stabilize prices. If living costs are stabilized and inflation expectations decrease, wage increases can be restrained, thereby reducing upward pressure on production costs.

The South Korean economy continues to experience low growth due to the weakening competitiveness of its main industries, while inflationary pressures persist due to rising import prices caused by a higher exchange rate. On top of this, the US tariff policy is likely to further intensify stagflation. Policymakers must stimulate domestic demand and curb increases in energy and public utility fees to lower inflation expectations and help the South Korean economy escape the trap of stagflation.

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