Middle East-driven inflation and high rates deliver a 'double squeeze'… a drag on the recovery

Inflationary pressure is intensifying in the wake of the war in the Middle East, raising the likelihood that high interest rates will persist for longer. Concerns are mounting that this could put the brakes on Korea’s economic recovery.

According to the financial markets on the 22nd, major central banks have recently held policy rates steady while reinforcing a “hawkish” stance. The move reflects rising price pressures stemming from higher international oil prices and uncertainty over the Middle East situation, sharply weakening expectations of rate cuts within the year.

In Korea, too, the monetary policy path appears to be losing clarity. While the prevailing view is that the Bank of Korea (BOK) will keep the policy rate unchanged, some are even raising the possibility of a hike in the second half. Bloomberg said the BOK could begin raising rates from the third quarter if oil climbs above $108 a barrel and the won-dollar exchange rate moves into the 1,500-won range.

External conditions have already deteriorated, with Brent crude topping $110 a barrel and the won-dollar exchange rate breaking above 1,500 won. Market rates are also rising, with the yield on three-year Korean Treasury bonds climbing to 3.410% per year.

Such a high-inflation, high-rate environment is a burden on the broader real economy. If higher energy prices and a weaker currency push inflation up while interest rates also rise, there is a strong likelihood that household consumption and corporate investment will contract simultaneously. Households and small and midsize enterprises (SMEs), which are heavily reliant on borrowing, are expected to be hit hardest.

The domestic demand recovery could also be shaken. The government has maintained a consumption-led recovery in domestic demand since November last year, but if rising cost burdens persist, consumers’ spending capacity could contract again, analysts say.

Exports are also exposed to these uncertainties. While export growth led by semiconductors is continuing, disruptions to logistics stemming from the Middle East have pushed up air freight rates, and if energy costs expand, corporate profitability could deteriorate.

Growth forecasts are also coming under downward pressure. Some experts say achieving this year’s 2.0% growth target will not be easy. Another analysis suggests that even with an early end to the conflict, growth could fall by 0.1 to 0.2%p, and if the war drags on, it could slip into the 0% range.

The government has moved to respond. It is considering compiling a supplementary budget worth up to 20 trillion won, while simultaneously pursuing inflation-stabilization measures such as monitoring prices of key everyday items and cracking down on collusion.

However, some point out that the policy impact may be limited. If higher interest rates curb private-sector demand, a fiscal expansion alone could have a limited effect in boosting the economy.

Experts say coordination between fiscal and monetary policy is needed. They assess that the economy is entering a phase where a “combined response” is unavoidable—fiscal policy should serve to cushion downside risks to growth, while monetary policy should focus on stabilizing inflation and the exchange rate.

Reporter Lee Song-ryeol, Hankyung.com yisr0203@hankyung.com