[Opinion] Controlling Inflation Remains Difficult Despite US Giant Steps

Juyushin, Dean of the Graduate School of Technology Management at Sogang University

The saying that predictions exist to be proven wrong feels very true. As U.S. inflation, which seemed to be under control, continues its high-level surge, the U.S. financial market is suffering. The U.S. Treasury yield (10-year) hovered above 3.4%, the highest in 11 years, and the Nasdaq stock index plunged nearly 5% in a single day last Monday.

In this situation, the Federal Reserve's benchmark interest rate, which was expected to rise by 0.25 percentage points just a month ago, was increased by 0.75 percentage points amid intense market attention. This is the so-called ‘giant step (0.75%)’ hike, the first in 28 years, surpassing the big step (0.5%) in May. The market is busy calculating the repercussions of the 0.75% rate hike. While there are concerns about further shocks to the bond and stock markets, some argue that a large rate hike has actually reduced the burden of future rate hikes and market uncertainty for the July and September FOMC (Federal Open Market Committee) meetings.

What will happen next? Although various opinions exist, the prevailing view is that because of the large rate hike, both bond and stock markets will initially plunge but then stabilize somewhat as the perception of a bottom spreads. In fact, U.S. stocks showed signs of rebounding immediately after the rate hike. However, personally, I would cast a vote for the opinion that the medium to long term outlook remains ‘shrouded in fog.’

The main reason is that I believe the Fed’s control over inflation is still not easy. Among the inflation drivers, non-economic supply chain factors such as Russia’s invasion of Ukraine are representative. For the U.S., these are external variables with no effective measures other than rate hikes, whereas Russia’s trade surplus has surged due to soaring prices of crude oil and other commodities, potentially making prolonged war a strategic option. Domestic inflation factors like rising wages and housing prices are equally burdensome if the massive fiscal funds released during COVID-19 cannot be absorbed early. Considering that both the Fed and the Democratic government, facing the November midterm elections, share the core goal of ‘controlling inflation,’ the risk of big step or giant step rate hikes could persist for quite some time depending on the war’s duration.

What’s particularly problematic is that at this point, it’s not just the U.S. we should worry about. As experienced multiple times in the past, continuous U.S. rate hikes have caused sharp currency depreciation, capital outflows, and in some cases, foreign exchange crises in emerging markets. Following Sri Lanka, Laos and Argentina are now at risk of defaulting on foreign debt repayments, and countries like Turkey and India are seeing their exchange rates hit record highs, increasing instability.

So, what about us? Despite three rate hikes this year, instability in the stock, bond, and foreign exchange markets continues. The KOSPI index, which was above 3000, has plunged below 2500, and the 3-year and 10-year government bond yields have reached 3.6?3.7%, the highest in nearly 10 years. The exchange rate is approaching 1300 won per dollar. South Korea’s foreign exchange reserves stand at $447.7 billion (as of the end of May), ranking 9th globally, and the proportion of short-term external debt is about 30%, which was generally considered to lower the risk of a foreign exchange crisis.

However, the current situation should not be judged by past standards. U.S. consumer prices have surged above 8% for three consecutive months, and the World Bank is warning of a price shock not seen in 50 years. Moreover, South Korea’s high export ratio and fully open capital markets mean that shocks to exports and imports can quickly translate into foreign investors selling stocks and bonds and dollar outflows, causing rapid exchange rate spikes. This suggests that the foreign exchange reserve structure could be vulnerable.

If the U.S. continues large rate hikes, the interest rate differential between Korea and the U.S. could reverse, increasing the risk of capital outflows. The interest rate gap between Korea and the U.S. has nearly disappeared, and Korea’s household debt to GDP ratio is 104.3%, the highest among major countries, making continued rate hikes difficult. Therefore, the government needs to work on securing currency swap agreements with the U.S. and prepare meticulous countermeasures such as joining the IPEF (Indo-Pacific Economic Framework) to prevent obstacles to exports to China.

Jung Yoo-shin, Dean of Graduate School of Technology Management, Sogang University

This content was produced with the assistance of AI translation services.