Rising fears of fiscal inflation call for careful policy mix

Kim Jung-sik The author is an emeritus professor of economics at Yonsei University. Korea's economy is facing the shock of "four highs": high oil prices; a weak won, as reflected in a high dollar exchange rate; high inflation; and high interest rates. Despite the possibility of a cease-fire in the Middle East conflict, tensions between Israel and Iran are expected to continue, making a return to prewar oil prices unlikely. The dollar-won exchange rate is also expected to hover in the mid- to upper-1,400 won range, and inflationary pressure from high oil prices and a weak currency is likely to rise with a lag. Increased fiscal spending has led to higher government bond issuance, and borrowing costs in the market are already trending upward amid persistent inflation. U.S. interest rates are also expected to rise. Before the conflict, expectations leaned toward rate cuts following stable oil prices and the U.S. midterm elections in November. However, concerns about inflation have grown as global supply chains shift after the war, raising the likelihood of policy tightening. Additionally, the Middle East conflict is expected to increase U.S. national debt, pushing up yields through expanded Treasury issuance. The combination of the four highs and rising U.S. rates poses a significant risk to Korea's economy. A deeper slowdown and expanding financial instability are key concerns. High inflation and borrowing costs tend to weaken domestic demand by reducing consumption and investment while increasing loan delinquencies. Exports are also likely to decline amid a global slowdown. At the same time, higher U.S. rates could accelerate capital outflows, further weakening the won. To respond, policymakers have introduced fuel tax cuts and price caps to counter high oil prices and expanded fiscal spending through supplementary budgets to support domestic demand. However, challenges remain in addressing financial instability, capital outflows, inflation and exchange rate volatility. First, macroprudential supervision must be strengthened. Unlike microprudential regulation, which focuses on individual financial institutions such as capital adequacy requirements under the Bank for International Settlements framework, macroprudential policy aims to maintain financial system stability in response to broader financial conditions. This approach draws on the "global financial cycle" theory proposed by Helene Rey, a professor at the London Business School. According to the theory, global bank credit flows linked to cross-border capital movements are closely associated with the CBOE Volatility Index (VIX), which is influenced by U.S. interest rates. When U.S. rates rise, the VIX increases, prompting global banks to reduce lending due to heightened risk aversion. This leads to capital outflows from emerging markets. A stronger dollar also increases the debt burden of firms in those economies by depreciating local currencies. Consequently, raising domestic interest rates alone is insufficient to prevent capital outflows. Instead, stronger macroprudential measures are needed to prevent financial crises and systemic instability. The theory also challenges the traditional "trilemma" of international finance and suggests a "dilemma" in which countries with open capital markets cannot fully maintain independent monetary policy. Korea has previously stabilized exchange rates by imposing levies on excessive foreign currency borrowing by banks. However, the current situation differs. Capital outflows are increasing due to rising U.S. rates and growing overseas stock investments by Korean residents. This suggests the need to strengthen macroprudential oversight of securities firms, not just banks. Authorities are considering reforms to exchange-traded fund systems and tighter supervision of overseas operations by securities firms. A gradual increase in interest rates is another policy option. While the global financial cycle limits the effectiveness of rat...