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INSIDabcdef_:MS_0001MS_0001
Impact from Changing Internal and External Conditions
on Korea’s Consumer Prices
Sora Chon, Fellow
1. Issues
With the majority of the world experiencing disinflation, Korea’s inflation
has remained below the target range for the past several years, calling for
an examination into the related factors.
The average inflation rate of
major advanced countries has
dropped 0.9%p since 2000,
posting 1.2% in 2012. A similar
trend can also be observed in Korea
Disinflation is caused not only by
domestic factors but also by
external supply and demand.
╺ An IMF analysis recently found
that the slack in the labor
market and decline in import
prices are the causes of global
disinflation.
╺ It is possible that domestic
consumer prices may have been
put under increased pressure
from external supply and demand
factors as a result of the
acceleration in the globalization
of the global economy since the
2000s.
Inflation: Major Advanced Countries
and Korea
(Year-on-Year % Change)
6
4
Korea
2
Major advanced
countries
0
-2
2000
2004
2008
2012
2016
Source: IFS
This study intends to empirically analyze the impact of the changes in
internal and external conditions on Korea’s inflation, and draw on policy
implications for future inflation.
This empirical analysis used domestic aggregate demand pressure as a
domestic inflation factor, and international oil prices (raw material prices)
and global aggregate demand pressure as external supply and demand
factors as well as the exchange rate.
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Impact from Changing Internal and External Conditions on Korea’s Consumer Prices
2. Recent Trends in Consumer Price Inflation
The decline in inflation since 2012 is due to the continued low growth of
services prices amid the sharp decline in commodity price growth.
With a downturn in the growth of industrial product prices, the average
growth of commodity prices posted 0.8% in 2012, far below that since
2000 (3.5%).
╺ Despite a temporary surge, the average growth of agricultural, livestock and
fishery product prices has remained markedly lower at 1.2% than pre-2011 levels.
╺ Significantly influenced by external conditions mainly via import prices, the average
growth of industrial product prices exhibited a sharp decline (0.9%) from
pre-2011 levels (3.1%).
The growth rate of services prices also stands below (1.7%) the pre-2011
annual average (3.0%).
╺ Compared to pre-2011 levels, the growth rates of public and personal services
prices have declined by a large margin, posting a low 0.9% and 1.7%,
respectively. Futhermore, they are likely to be highly sensitive to domestic
conditions.
╺ On the contra. the housing rent index exhibited a slight increase from pre-2011 levels.
Consumer Price Inflation by Component Post-financial Crisis
(YoY, %, %p)
Agricultural,
Consumer Commodity Livestock and Industrial Electricity, Services Housing Public Personal
Water,
Prices
Prices
Prices
Fishery
Products
Rent
Services Services
Gas
Products
Weight
1,000
453.2
77.6
326.6
49.0
546.8
92.8
142.6
311.4
2000~11
3.2
2012~16
1.3
2014
1.3
2015
0.7
2016
0.9
3.5
(1.5)
0.8
(0.4)
0.9
(0.4)
-0.7
(-0.3)
-0.4
(-0.2)
4.9
(0.4)
1.2
(0.1)
-2.7
(-0.2)
2.0
(0.2)
4.2
(0.3)
3.1
(1.0)
0.9
(0.3)
1.3
(0.4)
-0.2
(-0.1)
-0.4
(-0.1)
4.8
(0.2)
-0.4
(-0.0)
3.9
(0.2)
-7.4
(-0.4)
-8.2
(-0.4)
3.0
(1.7)
1.7
(0.9)
1.6
(0.8)
1.8
(1.0)
2.0
(1.1)
2.2
(0.2)
2.8
(0.3)
2.3
(0.2)
2.5
(0.2)
2.5
(0.2)
2.8
(0.4)
0.9
(0.1)
0.8
(0.1)
1.2
(0.2)
1.5
(0.2)
3.3
(1.0)
1.7
(0.5)
1.7
(0.5)
1.9
(0.6)
2.1
(0.7)
Note: 1) ( ) denote the contribution to overall consumer price inflation.
2) 2016 data is the Jan.-Nov. average.
Source: Statistics Korea.
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Impact from Changing Internal and External Conditions on Korea’s Consumer Prices
3. Empirical Analysis of Recent Consumer Prices
An analysis was conducted to examine the impact of changes in external
conditions on domestic consumer prices, taking into account major external
and internal macroeconomic variables including international oil prices,
global and domestic aggregate demand pressure and the effective exchange
rate.
Empirical analyses of consumer prices generally use domestic aggregate demand
pressure and import prices (hereinafter, won basis) as explanatory variables.
╺ Import prices include the impact from external supply and demand changes and
exchange rate fluctuations, and hence, the specific impact from the changes in
external factors cannot be discerned. .
╺ For instance, a reduced crude oil supply, increased external demand or a
depreciation of the won would cause import prices to rise, consequently
affecting domestic consumer prices.
International oil prices, global aggregate demand pressure and exchange
rates were used as explanatory variables, instead of import prices, to
distinguish the supply and demand factors.
╺ (Supply Factor) International oil prices (raw material prices) could directly affect
production costs in domestic firms, which could eventually change domestic
consumer prices.
╺ (Demand Factor) Major countries will see a decrease in commodity and services
prices on a downturn in global demand. This could cause a decline in the prices
of imported goods and services or fluctuations in the nominal exchange rate via
globalization, consequently affecting domestic consumer prices.
International Raw Material Prices
500
(1967=100)
(dollar/barrel)
Global and Domestic Aggregate
Demand Pressure
150
4
120
2
300
90
0
200
60
-2
30
-4
0
-6
400
CRB Index (Left)
Dubai crude oil (Right)
100
0
2000
2004
2008
2012
2016
Source: Bloomberg; Korea National Oil Corporation
(%)
Domestic
Global
2000
2004
2008
2012
2016
Source: OECD
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INSIDabcdef_:MS_0001MS_000
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Impact from Changing Internal and External Conditions on Korea’s Consumer Prices
A structural vector auto regression analysis was conducted to examine the
impact from unexpected external and internal shocks on domestic consumer
prices, using five variables: global aggregate demand pressures1);
international oil prices; the effective exchange rates; domestic aggregate
demand pressures2) and consumer prices.
To identify the respective shock factors, it is assumed that the above five
variables affect domestic consumer prices via a causal chain3).
╺ An external demand shock identifies the direct and indirect impact on domestic
consumer prices from unexpected global demand changes via global commodity
and services prices.
╺ An international oil price shock can be regarded as an external supply shock
because the changes in oil prices caused by an external demand shock have
been removed.
╺ An effective exchange rate shock identifies the impact on inflation via changes
related to monetary policy and foreign exchange flows.
╺ Domestic aggregate demand refers to the change in domestic aggregate
demand caused purely by domestic factors—excluding the impact on the
domestic economy brought on by external supply and demand shocks.
According to the estimated impulse response function, consumer prices are
susceptible to domestic demand. In addition external supply and demand
shocks were found to have played a significant role in the trajectory of
domestic inflation.
※ The impulse response function shows the degree of dynamic impact brought to
other variables when an unexpected shock occurs in each variable.
Above all, a shock that increases global aggregate demand by 1% results
in consumer prices rising by 0.2%p across approx. four quarters.
╺ This can be interpreted to mean that with Korea’s high external openness and
the accelerated integration of the final consumer market resulting from the
globalization of the global economy, the impact from changes in global goods
and services prices has significantly affected domestic consumer prices.
1) Global aggregate demand pressure is applied using the G20’s real GDP for which the long-term trend
line was HP filtered and removed.
2) Domestic aggregate demand pressure is KDI estimated.
3) It is assumed that global and domestic aggregate demand pressures, international oil prices and
effective exchange rates affect consumer prices in a sequential order.
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Impact from Changing Internal and External Conditions on Korea’s Consumer Prices
Next, a shock that increases international oil prices by 10% has a 0.1%p
impact on consumer prices; although the duration is shorter than that from
a global aggregate demand shock.
Meanwhile, a shock that increases domestic aggregate demand by 1%
raises consumer prices by 0.3%p. In addition, an effective exchange rate
shock also affects consumer prices via import prices.
These
findings
suggest
that
monetary
policy
should
comprehensively
consider the impact from both external and internal changes on domestic
consumer prices.
Repercussions of Shock Factors on the Domestic Inflation Rate
▎International Oil Prices
▎Global Aggregate Demand Pressure
0.6
0.6
0.4
0.4
0.2
0.2
0.0
0.0
-0.2
-0.2
-0.4
-0.4
-0.6
-0.6
4
8
12
16
20
4
24
▎Effective Exchange Rate
8
12
16
20
24
▎Domestic Aggregate Demand Pressure
0.6
0.6
0.4
0.4
0.2
0.2
0.0
0.0
-0.2
-0.2
-0.4
-0.4
-0.6
-0.6
4
8
12
16
20
24
4
8
12
16
20
24
Note: 1) The dotted line denotes the posterior credible interval at the 90% level.
2) The blue line denotes the repercussion to consumer prices in the event of a 1% positive
shock, except for the panel for international oil prices which assumes a 10% positive
shock.
Source: 2000Q1 – 2016Q3.
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Impact from Changing Internal and External Conditions on Korea’s Consumer Prices
Meanwhile, analysis on the contribution of respective shock factors to
consumer prices reveal that the ongoing disinflation since 2015 is mainly
due to the changes in external factors.
International oil prices slid by approx. 50% and 20% in 2015 and 2016,
respectively, causing consumer prices to drop by 1.0%p.
It has been estimated that external aggregate demand has caused recent
consumer prices to drop by 0.5%p.
On the other hand, domestic aggregate demand pressure shocks have had
a relatively small impact on consumer prices; a trend that has been
observed in the post-global financial crisis period.
╺ Domestic aggregate demand pressure has remained below zero in recent years,
but its contribution to consumer prices is low. This is because the aggregate
demand pressure in this study identifies only domestic changes which exclude
external factor-triggered influences on the domestic economy.
╺ For instance, a rapid drop in global demand triggered by the global financial
crisis caused domestic aggregate demand pressure to sharply reverse to below
zero via exports. Such a repercussion is recognized to be the result of a global
aggregate demand pressure shock, and not a domestic aggregate demand
pressure shock.
Meanwhile, the contribution of domestic aggregate demand pressure to
consumer prices has dwindled since the global financial crisis, while the
opposite is true for external aggregate demand pressure. This implies that
the recent economic slowdown and disinflation may have been caused
mainly by external factors.
Inflation Decomposition Results
(Deviation from the average inflation rate(2.6%), %p)
+3.0
+2.0
+1.0
+0.0
0.0
-1.0
-2.0
-3.0
Global Output gap
Dubai crude oil
Effective exchange rate
Other
Domestic Output gap
Inflation rate
2002
2004
2006
2008
2010
2012
2014
2016
Note: The line denotes the degree of inflation deviating from the average (2.6%) over the sample
period.
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INSIDabcdef_:MS_0001MS_000
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Impact from Changing Internal and External Conditions on Korea’s Consumer Prices
4. Inflation Prospects
Based on the above analysis results, Korea’s inflation is projected to stand
at a low 1%-range in 2017, still hovering below the target range (2%).
The following scenarios have been assumed to forecast the inflation for 2017:
╺ (Baseline scenario) Domestic aggregate demand pressure increases by –0.2%p,
but global aggregate demand pressure shrinks by 0.1%p. And international oil
prices rise by approx. 17% at around $48 per barrel.
╺ (High-inflation scenario) Domestic aggregate demand pressure remains similar to
the current level, and global aggregate demand pressure improves further than
in the baseline scenario, with international oil prices rising by approx. 25%.
╺ (Low-inflation scenario) Domestic aggregate demand pressure increases by
-0.3%p, but global aggregate demand pressure changes little from the current
level, and international oil prices rise by approx. 10%.
╺ Meanwhile, all scenarios assume a 0.1-0.2%p drop in inflation resulting from an
easing of the current progressive electricity billing system—this is a one-month
retrospective calculation as the launch is scheduled for 2017.4)
Therefore, Korea’s inflation is projected to mark 1.1-1.4% in 2017, implying
that the probability of achieving the inflation target (2%) is low.
Inflation Projections by Scenario
(Year-on-Year % Change)
2.0
Highinflation
1.5
1.0
Lowinflation
0.5
0.0
2013
2014
2015
2016
2017
Note: The line until 2016Q3 represents the actual figures while that from 2016Q4 represents scenario
estimates.
4) According to the Ministry of Trade, Industry and Energy’s public hearing materials, the revision is
expected to cause an average cut of about 11.5% overall, and the effect of a 1% adjustment is
estimated to contribute 0.021%p to overall consumer prices (Source: KEPCO).
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INSIDabcdef_:MS_0001MS_000
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Impact from Changing Internal and External Conditions on Korea’s Consumer Prices
5. Summary and Policy Implications
The disinflation in recent years has been significantly influenced by the
changes in external conditions and sagging domestic aggregate demand.
For 2017, inflation is projected to remain at a low level.
An empirical analysis found that fluctuations in consumer prices are
significantly influenced by domestic aggregate demand pressure shocks
while external factors such as international oil prices and global aggregate
demand pressure play a major role in the trajectory of domestic inflation.
╺ In particular, the disinflation since 2015 has been led by the changes in external
factors, implying that the recent domestic stagnation and disinflation may have
been caused mainly by external factors.
Meanwhile, given the macroeconomic conditions at home and abroad,
Korea’s inflation is expected to stand at a low 1%-range, still hovering
below the target.
Therefore, monetary policies should maintain an easing stance and active
countermeasures against downward economic and inflationary pressure
should be implemented when necessary.
Oil prices are expected to rise gradually. However, the weakening of
external and internal demand resulting from the recent stagnation in the
domestic economy and a global economy exposed to downside risks from
the political uncertainties in the US, amongst others, will most likely limit
any gains in Korea’s inflation.
To tackle the prolonged period of low inflation, the monetary authorities
should implement active measures to increase inflation according to
inflationary prospects and economic changes.
╺ With Korea’s long-term interest rates projected to rise, domestic monetary
policies should be further eased to tackle any mismatch between inflation and
interest rate as the resultant increase in the real interest rate could drag down
the overall economy.
╺ If inflation reaches the target, this could mitigate the downward pressure on
asset prices, helping the real estate economy to have a soft-landing.
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