By Sharon Lam

Inflation is now clearly a big risk for the economy. We have been highlighting this since the middle of 2010, warning that Korea has all the ingredients for higher inflation.

These include a prolonged low interest rate environment, strong domestic demand, tight capacity, and a low unemployment rate. We have urged that policies be implemented to pre-empt inflation.

There are arguments that Korea’s inflation is mainly due to import prices and therefore that the government should use currency appreciation to fight it.

Is Korea’s inflation imported? Well, let’s see. Inflation in this cycle started with food price increases, and part of that was imported. Yet part of it was also due to a poor harvest following heavy rains in the summer of 2010 and too much snow this winter.

The unfortunate outbreak of foot-and-mouth disease added further pressure on meat and dairy product prices. But what about demand?

Festival period demand over the last Chuseok and Lunar New Year was strong. Positive consumer confidence, higher incomes, and low interest rates on bank deposits are all driving stronger demand, as is eating out at restaurants, the increased demand from which has also contributed to higher food prices. So, food inflation is not due solely to imported food prices.

Commodity prices have picked up later than food prices in the current cycle, but they are also pushing up inflation now.

Korea is a heavy commodity importer for industrial use. Imported energy prices and raw material prices in the Korean won terms have risen 12.6 percent and 10.9 percent, respectively, since September 2010.

The increase in raw material prices has led to a rise in the producer price index (PPI), which rose to 6.2 percent in January from an average of 3.8 percent in 2010.

However, just as for food prices, cost-push factors cannot fully explain producer price inflation. Demand-pull inflation pressure is also present in the PPI.

Korea’s manufacturing capacity utilization rate has been hovering above 80 percent since the beginning of 2010, meaning capacity is tight.

Business surveys reveal that capital expenditure will only grow higher in absolute value this year to expand capacity to meet demand. In addition, the low interest rate environment is also encouraging capital expenditure growth.

So, food and commodity prices have triggered the increase in inflation. But now the pressure is clearly spreading to other prices.

Core consumer price index (CPI), which strips out food and oil, rose to 3.1 percent in February, from an average of 1.8 percent in 2010.

Again, the rise in core inflation cannot be fully blamed on import prices _ it is actually due more to stronger domestic demand. Services account for 60.4 percent of Korea’s CPI.

The service sector is affected less by external factors and more by domestic demand. The jump in core CPI means inflation is already affecting most consumers; thus, inflation expectations are rising and are being reflected in consumer sentiment surveys. When inflation expectations surge, this leads to an upward price spiral.

The upward price spiral, sustaining inflation at a high level, will threaten the economy.

We cannot just wait for international food and commodity prices to come down. We cannot just hope for foot-and-mouth disease to cease.

The country cannot rely on currency appreciation to fight inflation, considering the cost and effectiveness of intervention in the foreign exchange market.

It is difficult to see any sharp appreciation in the won this year, due to Korea’s declining current account surplus and capital outflow. It will be costly to fight such fundamentals.

It is not just about import prices. Korea needs to stop inflation expectations from soaring in order to halt the upward price spiral. A consistent policy stance is needed to manage consumer expectations on inflation.

When the CPI is above the central bank’s target range, the bank needs to take appropriate action. Unpredictable policy will only confuse the market and consumers.

Sharon Lam is Morgan Stanley economist