Inflation began to decrease in July. Considering the demand on the American economy, it is difficult to sustain an inflation rate of 6% to 7%.
News about inflation in the U.S. is frequently in the press these days. While this news may not seem like any of our business at first glance, inflation in the U.S. is actually important for South Korea as well. If inflation there continues to get worse, the Federal Reserve will raise basic interest rates in response. This will depreciate the value of the Korean won, increasing import prices, travel expenses, study abroad costs and foreign currency-denominated debt. Exporters might consider this an advantage, but rising import prices and an economic recession in the U.S. are not good news for them, either. Moreover, rising interest rates will lead to a less active stock market, imposing big losses on those who purchased U.S. stocks.
If the Bank of Korea raises the interest rate to offset this, loan rates in Korea will also increase, placing a heavy burden on households that borrowed money to buy houses, workers with negative bank balances and companies that borrowed money from the bank for investment. Considering the detrimental impact of American inflation on the Korean economy, we can only wonder when it will stop.
The U.S. used to struggle with severely high levels of inflation. For more than 20 years starting in the mid-1960s, the U.S. experienced an average inflation rate of 6%. Fed Chair Paul Volcker, appointed in 1979, raised interest rates up to 19% and eventually tamped inflation down. Since then, the U.S. maintained a low average inflation rate of 2.2% between 1985 and 2020, which is consistent with the Fed’s policy target of 2%. Before the current crisis, the Fed was more concerned about deflation than inflation.
But COVID-19, which started spreading in the spring of 2020, has brought about a major change in U.S. inflation rates. During the 26 months between April 2020 and June 2022, the inflation rate rose by 6.6% to 7%, the highest rate in the past three decades. There are several reasons why the inflation rate surged during this period. As unemployment soared in April 2020, the Fed decided to maintain the basic interest rate at 0% to 0.25% a year for a considerable period of time and supplied large-scale funds to the financial market to prevent a financial crunch.
In addition, the administrations of Donald Trump and Joe Biden have spent the equivalent of 5,000 trillion won (approximately $3.9 billion) to overcome COVID-19. On the supply side, as labor supply decreased and supply chains around the world faltered, costs for commodities, services and transportation rose. The Russian-Ukrainian war in the spring of 2022 raised energy and food prices.
As we mentioned, a series of events that began in the spring of 2020 created the perfect conditions for triggering rapid inflation. But the Fed did not start raising interest rates until March 2022 and is currently maintaining it at 4.25% to 4.5%, at a time when it has already exceeded 6%, however. In short, the Fed has failed to predict and take preemptive action against inflation because it was used to the stability of the past 30 years.
The Fed has vowed to raise interest rates this year as well. When will inflation end? What is certain for now is that what happened in the 1970s won’t happen again. Given changes in consumption, investment, real-life wages, national demographics and long-term interest rates over the past 50 years, the possibility of a sharp increase in total demand seems slim. Deflation will likely become a bigger concern for the U.S. economy again in a few years.
Looking at the short term, inflation seems to have peaked and entered a downward phase since last July, and this trend is likely to continue. Energy and food prices have stabilized despite the war in Ukraine. However, in the service sector, inflation continues to climb due to a shortage of labor supply.
If the inflation rate falls at the rate of inflation growth during the past two years, it will reach 2% in about 20 months, that is, mid-2024. No one knows for sure how much the Fed will raise interest rates to stabilize inflation in the future. The best outcome for the Fed would be if it could successfully control inflation without hurting the economy, but such an outcome would be close to a miracle. Historically, the Fed was met with applause when it managed to curb inflation while avoiding damage to the economy. The fact alone show such cases are rare. I hope that people will be able to cheer Fed Chair Jerome Powell this year, although the chances of that seem low.