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- Assessing the likelihood of a structural shift in interest rates (II): Economic structural change and inflation [24-05]
- Senior Research Fellow Kang, Hyunju and others / Feb. 19, 2024
- This study analyses the impact of economic structural variables, with a focus on globalisation and demographics, on the low inflation rate in Korea and the United States, and assesses whether changes in the inflation rate may occur in the future. This article examines the low inflationary conditions that have persisted since the 1980s from two perspectives: the flattening of the Phillips curve and the downward stabilisation of trend inflation. The flattening of the Phillips curve refers to the dampening of the sensitivity of inflation to the domestic economy, while the downward stabilization of trend inflation refers to the lowering of the underlying inflation rate, i.e. the long-term trend of inflation. From the 1980s to before the coronavirus pandemic, U.S.-Korean inflation was characterized by a downward stabilisation of trend inflation, while the flattening of the Phillips curve weakened the pro-cyclical nature of inflation, resulting in a stable low inflation rate.
This study empirically examines whether this low inflationary trend can be attributed to structural changes in the economy, such as globalisation and demographic change, along with the stability of long-term inflation expectations due to successful inflation management by central banks.
Before presenting the results of the analysis, we summarise the trends of globalisation and demographic changes in Korea and the United States from 1980 to 2020, the period of analysis. First, the world economy, including the Korean economy, entered the hyper-globalisation era in the 1990s, with significant progress of globalization. The U.S.-Korea globalisation entered the slowbalization phase around 2008 (U.S.) and 2013 (Korea), respectively. Next, this paper examines the demographic structure, focusing on the proportion of the working-age population (15~64 years old) and the elderly population (65+ years old) to the total population. The working-age population ratio in both countries has generally been on the rise since 1980, but it began to decline in the United States in 2008-2009 and in Korea in 2012-2013. In particular, the decline in the working-age population in Korea has been sharper than in the United States. As a result, the proportion of elderly people is increasing in both countries, but the proportion of elderly people in Korea is rising steeper than the United States.
The impact of these globalisation and demographic changes on the low inflation rate in Korea and the United States is as follows. First, our analysis shows that globalisation has played an important role in the flattening of the US-Korea Phillips curve. This result is observed for both headline and core inflation. In the case of the United States, where we were able to examine the role of long-term inflation expectations, the stabilization of inflation expectations also contributed to the decline in the cyclical sensitivity of inflation.
In our empirical analysis, globalisation is also found to have played a key role in the downward stabilisation of US and Korean trend inflation. After a large decline during the hyperglobalisation period, trend inflation in the two countries remained stable until the pandemic, suggesting that the decline in trend inflation during the hyperglobalisation period was largely driven by globalisation. This can be understood as a result of cost-efficiency improvements and increased competition among firms due to globalisation, as discussed in the existing literature. The impact of globalisation on trend inflation has been significantly lower in the US and Korea since around 2008 (US) and 2013 (Korea), respectively, reflecting the fact that globalisation in each country entered a plateau around the same time. In the United States, the stabilization of central bank-managed inflation expectations also contributed to the decline in trend inflation, with the impact mainly concentrated in the early to mid-1980s.
Second, differences were observed in the impact of demographic change on trend inflation between the two countries. First, in both countries, trend inflation rose as the share of the working-age population declined. This can be understood as a decrease in labour supply in the economy leading to higher inflation. On the other hand, for the elderly population share, trend inflation increased as the share increased in the US, but decreased in Korea. In the US, the elderly population can be attributed to their role as net consumers, consuming more than they produce. The elderly in Korea have been steadily increasing their participation in productive activities, and their spending power is much lower, so they have not been able to act as an inflationary force, unlike in the US.
The impact of demographics on trend inflation changed significantly when the baby boomers began to retire in each country (around 2008 in the US and 2013 in Korea). In both countries, the impact of demographic change on trend inflation was statistically significant, but economically limited compared to globalisation. In both countries, the impact of globalisation on trend inflation has largely outweighed the demographic effect.
However, in both countries, the impact of demographics on trend inflation has increased significantly as the baby boomers have begun to enter the elderly population. In the U.S., the share of the elderly population has been rising since before 2008, which has contributed to higher inflation, while the share of the working-age population has been declining since 2008, which has added upward pressure on inflation. As a result, after 2008, the impact of demographics on trend inflation exceeded the effect of globalisation and became a significant inflationary factor.
In Korea, the proportion of the elderly population has steadily increased since 1980, which has acted as a downward pressure on inflation. In addition, the share of the working-age population ended its upward trend around 2013 and entered a downward trend, turning it from a depressant to an inflationary factor. Until 2020, the period of empirical analysis in this study, the downward pressure on inflation due to the increase in the share of the elderly population was higher than the upward pressure on inflation due to the decrease in the share of the working-age population. However, using Statistics Korea's future population projections, it is estimated that from 2025 onwards, the upward pressure on trend inflation from the declining share of the working-age population will outweigh the downward pressure on trend inflation from the increasing share of the elderly population. This suggests that Korea's demographics are likely to be a structural driver of inflation in the future.
Along with a possible retreat from globalisation in the future, both Korea and the US are expected to experience a demographic transition in which the share of the working-age population declines and the share of the elderly increases for a considerable period of time. Applying the results of this study's empirical analysis to these economic structural changes, it is assessed that the low inflation rate that has remained stable in both Korea and the U.S. is likely to end and inflation volatility is likely to increase structurally. The steepening of the Phillips curve as a result of globalisation is likely to restore the cyclical sensitivity of inflation, which could lead to a structural increase in inflation volatility. We also expect trend inflation to rise as globalisation recedes.
- Assessing the likelihood of a structural shift in interest rates (I): Economic structural change and the real neutral interest rate [24-04]
- Senior Research Fellow Kang, Hyunju and others / Feb. 19, 2024
- Following the spread of COVID-19 and the steep rise in inflation, along with central banks in major countries raising interest rates, there is uncertainty about the future interest rate trend. There are contrasting views on whether we will return to the low-interest rates seen after the global financial crisis or if the long-standing trend of declining interest rates since the 1980s will be halted, resulting in a prolonged period of high interest rates. In this context, this report aims to provide the directional outlook for trend nominal interest rate fluctuations based on anticipated structural changes, such as demographic shifts, deglobalization, and productivity improvements.
Firstly, it has been statistically demonstrated that long-term government bond yields in South Korea and the United States maintain a stable relationship with the real neutral rate and trend inflation. Consequently, the factors influencing interest rates have been analyzed by distinguishing between the real neutral rate and trend inflation, leading to the creation of two research reports. This report, as the first part, primarily analyzes the impact of economic structural changes on the real neutral rate, summarizes and incorporates the outlook for trend inflation to be addressed in the second part, presenting the directional changes in trend interest rates and deriving policy implications.
To analyze the impact of economic structural variables such as demographic changes, productivity shifts, and national debt on the real neutral rate, forecasts for long-term real neutral rates in South Korea and the United States were estimated using UN population estimates, OECD productivity forecasts, and the National Assembly Budget Office's fiscal outlook. The analysis results suggest that the United States is expected to experience a rebound in the real neutral rate due to productivity improvements, while South Korea is forecasted to have a sustained plateau in the real neutral rate due to rapid population aging. Moreover, considering the results of the second part, which indicates a significant possibility of the end of the low inflation trend in South Korea and the U.S. due to future deglobalization and aging trends, it is concluded that global interest rates are likely to be stuck in a high-interest rate environment, and domestic interest rates are expected to find it challenging to return to the previous low-interest levels.
The directional trend of these interest rates poses challenges for fiscal policy in terms of the potential burden of interest costs due to expanding national debt and the possibility of fiscal expansion amid a household debt crisis. Regarding monetary policy, it raises challenges such as the central bank's dilemma in responding to supply shocks and the structural reversal of domestic and foreign interest rate differentials. Additionally, for the financial investment industry and pension funds, it suggests the need to consider changes in the relationship between asset yields and formulate new asset allocation strategies in response to market changes.
- Foreign Investor Dynamics in the Korean Government Bond Market: A Comprehensive Analysis and Policy Implications [23-09]
- Senior Research Fellow Kang, Hyunju and others / Dec. 18, 2023
- The share of foreign investors in the spot market for Korean government bonds has expanded significantly from just 1.6% in 2006 to nearly 20% in the second quarter of 2023. In particular, the share of foreign investors' trading in 3-year and 10-year government bond futures accounted for 44% and 53% as of 2022, making them major players in the government bond market. The influence of foreign investors in the government bond market is expected to expand further as the fiscal deficit is expected to continue for a significant period of time, and major domestic institutional investors such as national pension funds have announced plans to increase the proportion of overseas investments. Accordingly, analyzing the behavior of foreign investors in government bonds will become increasingly important for stable fiscal management and financial stability.
With this in mind, this paper examines whether the steep increase in the share of foreign investors in sovereign debt markets can be explained using empirical panel models for emerging economies. In addition, to understand the investment behavior of foreign investors in terms of financial stability, we analyze the impact of foreign trading on government bond yields and yield volatility by separating government bond spot and futures markets.
Using an econometric model that explains the share of foreign investment in local currency government bond markets in emerging economies, we find that the increase in the share of foreign investors in the spot market of Korea is consistent with the model, given the expansion of global liquidity and Korea's high sovereign credit rating. We also find that the trading behavior of foreigners in the spot market has not affected government bond yields or volatility so far.
On the other hand, in the futures market, where the share of foreigners is much larger than in the spot market, we find that foreigners' net purchases of government bond futures have a significant impact on the decline of government bond yields. In particular, the impact of foreigners' net purchases in the 10-year Treasury futures market is significant, and estimation by splitting the sample period confirms that the impact of foreigners in Treasury futures is even larger in the recent sample. On the other hand, despite the increase in foreign participation, we do not observe a significant wag-the-dog effect, where the price and volume of government bonds fluctuate rapidly on the expiration date, which may be due to the fact that the final settlement price in the government bond futures market, unlike the final settlement price of stock index futures and options, uses the average price calculation method on the expiration date.
Given the influence of foreigners in the government bond futures market, it is necessary to have a system that can detect and respond to abnormal trading behavior of foreign investors in the government bond futures market. It is necessary to expand the investor base by encouraging the participation of domestic institutional investors such as pension funds, insurance companies, and market makers in the government bond futures market to prepare for the possibility of clustering behavior by foreign investors in the event of an emergency. On the other hand, it is necessary to be cautious about increasing the share of retail investors in the government bond futures market, as a significant number of retail investors, unlike foreigners, have been analyzed to lose money in the market. With the listing of 30-year government bond futures on the horizon, it is necessary to strengthen retail investor education on the risks of investing in ultra-long-term government bond futures and consider improving the system to protect retail investors.
- Determinants of stock returns in Korea - A structural analysis based on capital investment returns [23-08]
- Research Fellow Jang, Bosung / Dec. 07, 2023
- This paper examines long-term structural drivers in the Korean stock market. The empirical analysis reveals that returns on capital investment effectively account for the long-term movements of stock returns from 1980 to 2021 period and that the average investment return declined after 2000. Theoretically, investment returns consist of two components: the return on the marginal product and the return on installed capital. In the 2000s, while returns on the marginal product saw a modest increase due to cheaper capital prices, the overall investment return fell due to decreases in returns on installed capital. This decline can be attributed to the deterioration of installed capital, influenced by large-scale restructuring following the Asian financial crisis, stagnant labor supply, and low growth potential.
Motivated by the empirical success, this study also presents projections on investment returns based on population scenarios provided by Statistics Korea. The projections for the next 20 years offer the following results. First, investment returns closely track population growth. Second, the cumulative investment return in the high (low) population scenario exceeds (falls short of) the median scenario by approximately 20%p. Third, a 7%p increase in labor supply from the 50-64 age group and a 10%p increase from females lead to substantial increases of 24%p and 36%p in the cumulative investment return, respectively.
Notably, the returns from the scenarios with increased labor supply outperform that with a total 0.3%p increase in total factor productivity (TFP) growth over 20 years. Considering that TFP growth in the 2000s has dropped by half compared to the 1980-1990 average, its improvement seems challenging. Consequently, the findings suggest that improving the labor market is essential to counteract the slowdown in TFP growth, benefiting both the real economy and the stock market in Korea.