Not since the early 1980s have countries in the world experienced substantially high inflation rates. Only recently has world inflation skyrocketed at a rapid pace over the course of the past year and a half. This is reminiscent of the unprecedented episode of high inflation during the 1970s. What are the causes of recently high inflation that the world has been experiencing? What are the effects of persistently high inflation in advanced economies such as the U.S. on the Korean economy?

In a broad sense, macroeconomic theory suggests two major causes of a rise in prices. The first one comes out of the demand side (i.e., demand-pull inflation) and the second one stems from the supply side (i.e., cost-push inflation). Demand-pull inflation, as the expression suggests, hinges fundamentally on a rise in prices of any elements germane to demand such as consumption and investment, etc. However, cost-push inflation implies a rise in prices of any factors related to supply such as raw materials, energy and production factors, etc.

In fact, it is too complicated to choose either the demand side or the supply side for the high inflation we are experiencing currently, but the increase in prices appears to follow from a combination of these two sides. The post-pandemic recovery of the world economy with low interest rates and fiscal expansions drives up overall demand for goods and services that were not readily available during the pandemic slump. Meanwhile, the energy crisis after the Ukraine-Russia war and a rise in wages in advanced economies such as the U.S. and European countries have been major threats to inflation. The basic demand-supply analysis on this situation tells us that a surge in demand and a drop-in supply leads to a rise in prices, resulting in high inflation.

Most central banks have responded to this situation by forcefully increasing their policy rate to curb high inflation. Despite this policy action, however, central banks face a risk of monetary tightening due to a possibility of recessions. As a matter of fact, the recent decision by the Bank of Korea seems to reflect this concern: It determined to keep the policy rate identical to the one in the last month.

That said, the Bank of Korea officially adopts inflation targeting as a monetary policy framework that sets a 2% inflation rate. The same is true for the U.S.: It has a specific inflation target of 2 percent as an ultimate goal and aims at achieving full employment. It implies that it is hard to give up the fight against inflation for credibility of monetary policy.

Furthermore, the most recent U.S. economic indicators such as inflation rates, wage growth and job growth allude to the situation where it is not easy to see a slowdown in inflation sooner or later. It suggests that it is possible for the Fed to raise the policy rate more than what it originally announced in February 2023. Korea is not an exception: A recent publication showed that expected inflation rose again. All of these statistics imply that curbing inflation may not be easy and it is possible to entrench high inflation during prolonged periods.

The fact that it is highly likely that the Fed raises the policy rate several times this year and the U.S. monetary policy has significant spillover effects on other countries does not seem to give many policy options to the Bank of Korea. Though much uncertainty in future economic states makes it hard to predict the exact policy rates in the future, the rise in policy rates will not stop for now to bring down inflation.

By Choi Yoon-seok, Associate Professor, Faculty of Economics