[Insight & Opinion] The Advent of the Inflation Era and the Financial Pandemic

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The era of inflation has begun. Jerome Powell, Chairman of the U.S. Federal Reserve (Fed), which effectively manages global liquidity in the world economy, reset the direction of monetary policy to an ‘average inflation targeting’ framework in August 2020. This meant that as long as inflation does not exceed an average of 2% in the long term, temporary inflation above 2% would be tolerated.

This change was interpreted as the Fed expecting inflation to not be a serious problem in the future and placing more emphasis on promoting employment. Although inflation rates increased after this announcement, Chairman Powell maintained until September last year that inflation was a ‘transitory’ issue.

However, the situation has rapidly changed. At an International Monetary Fund (IMF) discussion last Friday, Chairman Powell referred to former Fed Chairman Paul Volcker, who suppressed inflation in the 1980s through sharp interest rate hikes, making it clear that last month’s Fed rate hike was only the beginning.

The current inflation problem can be seen as a complex result of supply-demand imbalances caused by COVID-19 and the Ukraine war, as well as excessive liquidity supply in response to COVID-19. While there may be debates among scholars about the main causes of the current inflation, there is considerable consensus that the current inflation is not a ‘transitory’ issue.

Charles Goodhart, former Governor of the Bank of England, stated, "The COVID-19 pandemic will be a crucial turning point separating the deflationary pressures of the past 30-40 years from the inflationary era of the next 20 years." The new era of inflation has already begun.

The most direct problem caused by inflation is the reduction of real disposable income for ordinary citizens. Life for ordinary people will become more difficult in the inflation era. Since economic recovery is not proceeding at the expected pace, the economic hardships felt by ordinary citizens will intensify for the time being. However, a more serious issue is that inflation could escalate into a financial crisis.

Since the Volcker shock in the 1980s, controlling inflation has become an inviolable principle of the Fed. Chairman Powell’s announcement of the average inflation targeting was because he expected inflation not to be severe, not an intention to relax the Fed’s core principle of inflation control.

Therefore, there is no doubt that the Fed will raise its benchmark interest rate in the inflation era. However, the Fed’s rate hikes will cause global interest rate increases along with capital inflows into the U.S. Developing countries with significant debt levels or low-income households will inevitably face considerable financial burdens.

Moreover, if a financial crisis occurs anywhere in the world due to an inability to withstand debt pressures, a financial virus will spread rapidly worldwide just as the coronavirus did in a short period.

Now, while still fighting the COVID-19 pandemic, we must also prepare for a ‘financial pandemic.’ However, it is highly questionable whether international cooperation to prevent a financial pandemic is possible in the current international order dominated by self-help. If not, at least South Korea must prepare its own self-help measures against a financial pandemic.

Jae-Hwan Jeong, Professor, Department of International Relations, University of Ulsan

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