Inflation Risk and Counter-Measures
Jin-Young, Chung, SERI Quarterly
Inflation risk, price indices, quantitative easing, speculative demand, Chinaflation
LOOMING INFLATION RISK
Domestic Price Trends
Major price indices like the consumer price index, producer price index, and import price index are showing an upward trend. Consumer prices in the first half of 2011 rose 4.3 percent year-on-year with those in August spiking 5.3 percent. In the first quarter, the raw material sector (including farm, livestock & fisheries, and petroleum) accounted for a substantial portion of the higher consumer prices, while in the second quarter the service sector was the main factor. The producer price index rose 6.6 percent year-on-year in the first half, driven by higher import prices for raw materials. After peaking at 19.6 percent in March due to strong raw material prices caused by political instability in the Middle East, the import price index returned downward thanks to stabilization of political turmoil coupled with a falling won-dollar exchange rate. As of August, the import price index was 10.0 percent higher than that of a year earlier.
Price hikes ignited by overseas supply shocks have led to higher service prices, and escalating upward pressure on consumer prices on the demand side. Service prices, which remained stable in 2010 (with an average growth rate of 1.9 percent), have increased sharply in 2011, growing by 3.0 percent in July. After remaining stable in 2010 at a rate of 1.8 percent, core inflation prices (excluding volatile food and energy costs) accelerated in 2011, with the rate rising to 3.8 percent in July 2011. This indicates that the basic trend in consumer prices, excluding temporary external shocks, is turning upward.
Main Drivers behind Recent Price Hikes
International prices of raw materials and agricultural products
An increase in international raw material prices has triggered hikes in domestic import and producer prices, thereby leading to an increase in domestic consumer prices. Thus, the increase in international raw material prices served as a main factor behind price instability.
Since the collapse of Lehman Brothers Holdings, international prices of raw materials have surged sharply on economic recovery led by emerging markets and fierce competition to secure raw materials among major commodity importers (including China). China's oil consumption rose approximately 10.5 percent in 2010, and accounted for an estimated 35.7 percent of the growth in global oil consumption. Against this backdrop, the per-barrel cost of Dubai oil climbed to $111.1 by the end of July 2011 after plummeting to $38.9 in December 2008. The international prices of copper and iron ore also marked robust increases.
Prices for agricultural and livestock commodities continued a marked rise due to poor harvests worldwide caused by a series of natural setbacks, including abnormal weather conditions and earthquakes, raising concerns over the potential for "agnation."
According to the Food and Agriculture Organization (FAO) of the United Nations, the food price index surged in the latter half of 2010, rising 39.1 percent from June 2010 to June 2011. In particular, prices for major agricultural commodities like soybeans, wheat, and corn rose sharply due to higher demand from fast-growing emerging markets (including China). In the 2010/11 planting season, global grain consumption is forecast to rise 2.2 percent year-on-year. In contrast, global grain production is likely to decline by 2.2 percent, while global grain inventories are expected to fall by 3.2 percentage points.
Against this backdrop, international grain prices are expected to maintain their upward momentum for the time being, largely because of excess demand. In addition, international prices for corn, soybean oil, and canola oil - major ingrethents of bio-ethanol and bio -diesel - are also showing signs of rising amid higher demand for bio-energy, which is gaining popularity as a fossil fuel alternative due to high oil prices.1
Boosted by ultra-low US interest rates and quantitative easing policies, speculative demand for raw materials was one of the chief factors elevating international prices of oil, minerals and agricultural commodities. The net buying of Dubai oil for non-commercial use jumped sharply in the fourth quarter of 2010, while speculative buying of major grains like soybeans and corn has also increased.2
The spread of "Chinaflation" risk
The average price of Chinese exports is continuing on an upward trajectory, fueled by an increase in production costs (resulting from deepening labor shortages and higher minimum wages), foreign exchange reforms, and a ballooning current account surplus.
In China, increases in producer prices and appreciation of the yuan added to the upward pressure on Korea's import prices, placing a burden on Korean producer and consumer prices. Under these circumstances, worries are mounting over the burst of China inflation.
In 2010, China accounted for the highest share of South Korea's imports, 16.9 percent. In particular, China supplied 15.1 percent of South Korea's agricultural commodities - a main driver behind growing consumer prices.3
COUNTERMEASURES FOR PRICE STABILIZATION
Short-term: Micro-policies for Price Stability and Gradual Rate Hikes
Since the hike in consumer prices was triggered by overseas supply factors, the range of shortterm policy options is limited. Accordingly, it is desirable to focus on micro -policies in price management.
Public utility prices will inevitably need to be raised. To mitigate the scope of the increase, hikes should be gradual and irregularly timed. According to an analysis of the ripple effect of public utility prices using the input-output table for 2005, utilities have more impact on consumer prices than oil prices. This implies positive effects of micro -policy measures for price stabilization, including gradual increases in public utility fees.
In tandem with micro policy measures, centered on stabilizing the prices of necessities, efforts should also be made to cope with demandside upward pressure on consumer prices. Anxiety about consumer prices is growing, with the expected inflation rate estimated at 4.0 percent in July 2011, after hovering at 3.0-3.2 percent in the first half of 2010. Given these considerations, efforts are needed to prevent the spread of inflation-anticipating sentiment via gradual increases in interest rates at an appropriate level.
Mid- and long-term Measures: Structural Reforms
Given that the prices of agricultural commodities are highly volatile due to non-elastic supply and demand, primary emphasis should be placed on suppressing price volatility factors while reforming the retail structure of agricultural commodities. Accordingly, efforts should be made to improve the storage of agricultural commodities, as well as to minimize the impact of external risks like climate change and damage by insects. Better forecasting of agricultural supply and demand, as well as wider coverage of farm disaster insurance policies can also smooth supply disruptions.
Another area for improvement is pricing of agricultural commodities. Efforts are needed to stabilize prices by bolstering retail efficiency. To this end, the retail structure in farming areas should be improved by promoting a systemized structure among producers and standardizing the selection of agricultural commodities even at harvest time.
Distribution to retailers needs to be rationalized while wholesale market operations need to be improved to establish a low cost, highly efficiency structure. In the wholesale market, flexible application of private contracts and fixed-price transactions in lieu of a tender-based system can boost efficiency.
To strengthen supply-demand management for major agricultural products, efforts should be made to secure stable supplies overseas. The following countermeasures should be taken to effectively contain price volatility, which can stem from an increase in import prices of agricultural commodities driven by speculative demand and adverse weather.
First, supplies of agricultural commodities should be secured through joint and direct purchasing. Suppliers of agricultural commodities should expand their inventories through commodity spot and futures markets to improve their share of joint and direct buying of agricultural commodities. At the same time, the government needs to finance some expenses. Further, more import sources for agricultural commodities are needed. Private companies should be encouraged to take a large role in agricultural development projects for developing countries. Second, the risk of price volatility should be reduced by improving the global retail structure. Major retailers focusing on the Asian agricultural commodity market, should be cultivated, to ease inflationary pressure. Third, monitoring capability should be improved to ensure better response to price volatility. In particular, the ability to detect shifts in momentum in international grain markets and to thereby anticipate potential price volatility should be fostered. By monitoring the international grain market, the database of information on the supply-demand situation, the price outlook, and the degree of risk should be established and distributed to the parties concerned.
To remove price instability caused by hikes in import prices, efforts should be made to improve the rates of self-supply and self-sufficiency for major agricultural commodities and raw materials. By lowering the level of import concentration in a particular country, supply instability from changes in the geopolitical environment can be eased. To this end, efforts are needed to diversify import sources for agricultural commodities while improving import structures for major raw materials, which depend heavily on select regions and countries. In conclusion, lower import prices and additional export outlets should be pursued by strengthening strategic trade partnerships with major agriculture/livestock and raw material-producing countries through mutual tariff reductions.
Translation: Shin Jun-Sup
The global credit crunch beginning in 2007 has resulted in a flood of new money flowing into the world economy. Much of this money is now chasing higher returns in the emerging market world, spurring concerns of asset bubbles and overheating. In particular, the rash of new funds is helping to stoke inflation. The current liquidity will need to be carefully managed to avoid a sudden hard landing.
1 OECD (2010. 6.). OECD-FAO Agricultural Outlook 2010.
CHUNG Jin-Young is a research fellow at SERI. His research areas cover international trade, investment, business and finance. He holds a PhD in Economics from the University of Washington. Contact: email@example.com…
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Publication information: Article title: Inflation Risk and Counter-Measures. Contributors: Jin-Young, Chung - Author. Magazine title: SERI Quarterly. Volume: 4. Issue: 4 Publication date: October 2011. Page number: 113+. © Not available. Provided by ProQuest LLC. All Rights Reserved.
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