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CHUNG Jin-Young

How to Cope with Rising Inflation

CHUNG Jin-Young

Jan. 31, 2011

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Fears over inflation are deepening. Consumer prices rose 3.5% in December compared to a year ago, while producer prices increased 5.3% and import prices 12.7%. Driving up consumer prices were agricultural products, which leaped 26.5% on the back of a 33.8% surge in fresh produce prices. Among import prices, agricultural/forestry/fisheries product prices soared 30.8%.

The backdrop to the price spike is a mosaic of supply-side factors. With rising demand for raw materials by commodity importers like China, demand-supply dynamics are being recalibrated. In addition, weakening US dollar and expanding global liquidity have prompted speculative demand, putting upward pricing pressure on commodities, including oil.

The price of Dubai crude, which Korea depends upon, climbed to US$93.2 per barrel as of January 14, far higher than the US$80 average estimated for 2011. Net-long positions of non-commercial traders in Dubai crude futures also surged in the fourth quarter of 2010, reflecting the rising oil prices coming from speculative demand.

Meanwhile, the agricultural sector is under mounting stress. Low harvest outlooks due to weather extremes plus rising demand by consumers in emerging economies are fanning concerns over food price inflation, or agflation. According to the Food Association Organization under the UN, the fresh food price index, which has a bearing on Korean domestic prices, rose 32% in the second half of 2010. Rising raw material prices have spurred demand for bio energy, leading to upward price pressure on corn, soybean oil and rapeseed oil, which are needed to produce bio ethanol and biodiesel.

Another source of imported inflation is coming from China, Korea's trade partner. Chinese products, 16.9% of Korean imports, are arriving with higher and higher price tags, which will be passed on to consumers.

Fortunately, upward price pressure from the demand side has been arrested so far. Considering the stable core inflation rate and a negative GDP gap RATE, inflationary pressure coming from demand factors such as easy credit and rising incomes has yet to appear.

Although overall consumer prices are trending upward, the core inflation rate remains stable at 2% (in December 2010). The GDP gap rate, which fell to negative 3.2% right after the collapse of US investment bank Lehman Brothers in September 2008, has improved, and is likely to post a negative 0.5%. This means that actual GDP will remain below potential GDP, or a slight slowdown in 2011. That will constrain demand side pressure on inflation this year.

Since rising prices are coming from the supply side and external factors, short-term plans to tame inflation should be on a micro level. They could include a freeze on public utility charges, stabilizing monthly rental prices and farm product prices and containing education costs. These are all related to stabilizing prices related to low-income households. According to industry input/output table in 2005, the pace of rise in consumer prices from rising public utility charges topped the pace of rise in prices from rising oil prices.

At the same time, measures will be needed to prevent price stabilization steps do not raise the tax burden. But the most important effort will be to dispel inflation fears.

Even if the prices are stabilized, fears over future inflation would be enough for households to rein in domestic consumption and crimp the economy, which already is expecting a slowdown in all-important exports this year. In this regard, it is crucial for the government to focus policy on fear of inflation through micro measures.

Because food is the most frequent purchase, consumer perception and subsequent expectation about inflation exceeds what actual data reveals and suggests. Nevertheless, there is no denying that farm products are the main cause of the recent inflation surge. Thus, fundamental measures should focus on preventing agflation. The uncertainty on domestic grain production should be eased while the distribution of domestic farm, fisheries and forestry products should be effectively managed to stabilize these prices.

In addition, it is crucial to secure overseas agricultural suppliers to cope with speculative demand and global climate change. Building overseas food production bases, developing overseas food resources and vitalizing direct overseas transactions and diversification of import sources are crucial. Introduction of a way to import grains through the grain futures market can help strengthen risk management of import prices of grain, while introducing an early warning system for a stronger monitoring of international grain market.

Even if the agricultural sector's effect on prices is effectively contained, there is no guarantee high inflation will be absent. If service prices, currently at a stable level, rise, the government's price stabilization measures can lose their effect. Service prices account for 60% of Korea's consumer prices so any fast, appreciable increases would likely stir as much discern as the current rise in food prices.

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