[fn Plaza] What Are We Going To Do About Inflation?

As fuel prices soar, any gas station offering even slightly cheaper gasoline is jammed with cars lining up to fill their tanks. The rarely seen circuit breaker mechanism that halts steep stock declines has been triggered repeatedly. The Korea Composite Stock Price Index (KOSPI), which had climbed above 6,000, at one point plunged in an instant to the low 5,000 range. The US Dollar–South Korean Won exchange rate surged to just below 1,500 won. People everywhere were asking in despair, "Has a war broken out in South Korea?" Since then, the KOSPI has rebounded sharply and the exchange rate has turned downward, meaning the won has strengthened. Even so, market anxiety has not disappeared. This is the scene in South Korea following the Middle East crisis that began late last month with attacks on Iran by the United States of America (U.S.) and Israel.
Tehran, the capital of Iran, is about 6,500 kilometers away from Seoul. No missiles or shells have fallen on Seoul. Yet the market was so shaken that for six consecutive trading days circuit breaker mechanisms, sidecars and other market-stabilizing tools were activated. Panic buying of fuel, the kind of thing you would expect only in wartime, also took place.
Instability in the energy supply chain lies at the root of this turmoil. Iran is a major oil producer and controls the Strait of Hormuz, through which 27% of the world’s crude oil shipments pass. South Korea, the world’s seventh-largest oil consumer, imports most of its crude from the Middle East. As the risk of Iran blocking the strait rises, the economy inevitably goes into convulsions. Higher oil prices widen the trade deficit and weaken the value of the won, fueling exchange-rate volatility. On top of that, South Korea’s economic and industrial structure is energy-intensive. Among the 37 members of the Organisation for Economic Co-operation and Development (OECD), it has the highest dependence on crude oil. The amount of money spent on importing oil is astronomical, creating a vicious cycle. In this context, a warning by The New York Times (NYT) about the Middle East crisis is on point: "South Korea spends more than $100 billion a year on energy imports, so rising energy prices could worsen its trade balance."
Rising prices for goods and services and a weakening job market are all but guaranteed. In an economy like South Korea’s, where domestic demand is relatively small and growth is driven by exports, a sharp jump in oil prices is the starting point of strong inflation. An "oil shock" can spill over into the real economy very quickly. According to an analysis by Hyundai Research Institute, if oil prices stay at $100 per barrel, economic growth falls by 0.3 percentage points, consumer prices rise by 1.1 percentage points, and the current account balance deteriorates by $26 billion. In the real economy, airlines would face additional annual costs in the 1 trillion won range, and petrochemical companies could be forced to halt operations because they cannot secure "industrial rice" Naphtha from the Middle East.
Right now, the fundamentals of our economy are not strong, and our capacity to absorb oil price shocks is weak. The government’s growth forecast of 2% for this year assumes international oil prices in the low $60 range. If high oil prices persist for more than a month or two, inflation and a cooling of the real economy could occur simultaneously. The economy’s "growth plate" could close, opening the door to stagflation.
Curbing inflation must be the top priority. According to the Ministry of Data and Statistics (KOSTAT), consumer prices in February rose 2.0% from a year earlier. That figure does not reflect the impact of the war. It is hard to predict what inflation will look like in March. In that sense, it was appropriate that President Lee Jae Myung of South Korea, while presiding over an Emergency Economic Review Meeting on the 9th, ordered preemptive measures to prepare for the worst-case scenario. The expansion of the 100 trillion won market-stabilization program that the president mentioned, along with efforts to secure alternative supply routes that bypass the Strait of Hormuz, are urgent tasks. The maximum oil price system is a policy that stands out for its speed of implementation. It is likely to help contain inflation expectations. In extraordinary times, extraordinary responses are needed.
There is, however, a condition. Artificial price controls require fiscal spending. Because they are not sustainable, their side effects must be examined carefully. There have been past cases where governments tried to block politically sensitive increases in fuel prices, especially gasoline. In 2011, during the Arab Spring, the Cabinet of Lee Myung-bak pressured refiners to cut prices by 100 won per liter for three months, but the policy quietly faded away afterward. This is why the focus should be on improving the pricing structure—where international oil price hikes are passed through quickly, but declines are reflected only slowly—and on stabilizing supply chains.
Because prices have the greatest impact on the lives of ordinary people, they are often described as the prime target of populism everywhere. As the President of the Republic of Korea has noted, crises always hit low-income households hardest. With the June 3 Local Elections approaching, it may not be easy to push ahead with long-term policies to stabilize energy supply and demand and to ride out the inflationary wave. Even so, this crisis must be used as an opportunity to overhaul the energy supply chain. Policies should aim to diversify import sources to reduce South Korea’s heavy dependence on the Middle East and to expand nuclear power plant (NPP) capacity. That is the best possible anti-inflation strategy.
mirror@fnnews.com Reporter