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INSIDabcdef_:MS_0001MS_000 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. 1 INSIDabcdef_:MS_0001MS_000 INSIDabcdef_:MS_0001MS_0001 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. 2 INSIDabcdef_:MS_0001MS_000 INSIDabcdef_:MS_0001MS_0001 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 3 INSIDabcdef_:MS_0001MS_000 INSIDabcdef_:MS_0001MS_0001 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. 4 INSIDabcdef_:MS_0001MS_000 INSIDabcdef_:MS_0001MS_0001 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. 5 INSIDabcdef_:MS_0001MS_000 INSIDabcdef_:MS_0001MS_0001 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. 6 INSIDabcdef_:MS_0001MS_000 INSIDabcdef_:MS_0001MS_0001 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). 7 INSIDabcdef_:MS_0001MS_000 INSIDabcdef_:MS_0001MS_0001 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. 8