KDI - Korea Development Institute - RESEARCH - Economic Outlook

Summary

KDI Economic Outlook 2025-2nd Half Recent Low Unemployment Rate: Drivers and Implications

■ Despite recent economic weakness, the persistence of low unemployment reflects two opposing forces: rising worker discouragement and improvements in matching efficiency.

- These two forces were already placing downward pressure on unemployment before the COVID-19 crisis. As labor demand strengthened after the crisis, unemployment fell sharply and has remained low despite recent softening in employment conditions.

- Advances in matching technology and demographic shifts have substantially improved matching efficiency, continuing to push down the unemployment rate.

- At the same time, the increasing number of discouraged workers, especially among the young, has mechanically lowered the headline unemployment rate.

■ This implies that low unemployment does not necessarily signal improved employment conditions.

- A substantial share of the unemployment decline reflects young workers exiting the labor market. This suggests that, as the job creation capacity of firms has weakened and the labor market duality has deepened, a growing share of young people have become pessimistic about securing high-quality, regular employment and have stopped searching for work altogether.

- If these structural barriers that discourage job search among the young become entrenched, participation in an already shrinking workforce could decline further, posing risks to social cohesion.

■ Accordingly, efforts to improve matching efficiency should continue alongside measures to reduce labor market duality and strengthen incentives for workforce participation.

- It would be advisable to improve business productivity to create quality jobs, ease the labor market duality, and gradually align the education system with industry needs.

- Additionally, in-depth analysis of the growing “taking a break“ population should continue to inform the detailed design of mechanisms to help those who have been out of the workforce for extended periods return to work.

Summary

KDI Economic Outlook 2025-2nd Half Increasing overseas investment: Macroeconomic Context and Implications

■ As in Japan’s case, the slowdown in productivity growth has been a major driver of declining capital returns in Korea, leading to a shift from domestic to overseas investment.

- Looking ahead, a shrinking working-age population will weaken labor input and domestic capital returns, further accelerating the shift toward overseas investment.

- A productivity slowdown directly reduces GDP and also shrinks the domestic capital stock, amplifying the total impact on GDP to about 1.5 times the direct effect.

- In Japan, where productivity and demographic shifts occurred about twenty years earlier than in Korea, slower productivity growth led to a marked loss of economic dynamism and greater reliance on investment income from abroad.

■ Therefore, restoring growth momentum will require sustained structural reforms that boost productivity.

- If the productivity slowdown persists, adverse effects may broaden, particularly for those who depend heavily on labor income.

- This will require building an environment that enables innovative firms to enter and unproductive firms to exit, alongside a more flexible labor market that supports economy-wide productivity growth.

※ The shift to overseas investment arises from declining domestic productivity and helps offset the resulting loss in national income. It would therefore not be advisable to restrict it by policy.

※ Since the current account surplus is equivalent to net overseas investment, an increase in the surplus should be interpreted with caution.

Summary

KDI Economic Outlook 2025-1st Half Potential Growth Outlook and Policy Implications

■ Demographic changes will continue to depress Korea’s potential growth rate, projected to be near 0% by the 2040s.

- With 2025’s potential growth rate in the upper 1% range, the baseline scenario projects negative growth by the late 2040s, while the pessimistic scenario, with delayed structural reforms, anticipates its onset by the early 2040s.

- Accordingly, policy efforts should prioritize TFP enhancement through structural economic reforms.

- Simultaneously, policies should counter demographic-driven labor force decline by promoting workfamily balance, elderly labor participation, and labor market openness.

■ Slowing growth may push down the neutral real interest rate, increasing the risk of hitting the zero lower bound. This calls for reviewing the monetary policy framework to stabilize inflation expectations.

- If the neutral real interest rate declines alongside low inflation expectations, the nominal interest rate (= real rate + expected inflation rate) may remain subdued, constraining rate cuts. A balanced approach is therefore needed to address both upside and downside inflation risks.

- High interest rates, maintained for financial stability as a newly adopted monetary policy objective, may lead to disinflationary effects. Therefore, monetary policy frameworks should balance financial stability and inflation expectations through careful evaluation.

■ With slowing potential growth expected to strain government fiscal soundness, caution should be exercised to prevent repeated stimulus measures from creating structural budget deficits.

- A shrinking tax base from slower growth will strain public finances, requiring reforms to fiscal systems designed with the assumptions of high growth and labor participation

- To boost economic dynamism, policy efforts should prioritize correcting market failures and reforming distortionary systems over fiscal spending.

- Misreading potential growth decline for a cyclical downturn and using repeated stimulus measures could undermine fiscal soundness and macroeconomic stability.

Summary

KDI Economic Outlook 2025-1st Half The Impact of Recent Exchange Rate Fluctuations on Prices

■ An increase in the KRW/USD rate driven by dollar strength exerts short-term upward pressure on consumer prices, but its persistence and pass-through are more limited than when driven by domestic factors.

- The impact of dollar-driven KRW/USD fluctuations on import prices diminishes with time, while that of domestic drivers gradually strengthens.

- Both dollar and domestic factors have similar short-term effects on consumer prices, but the impact driven by domestic factors becomes more pronounced over time.

■ Analysis of recent KRW/USD fluctuations shows a significant influence from dollar factors on consumer prices. Scenario analysis suggests that, unless
the exchange rate rises sharply, inflation will likely not significantly exceed the Bank of Korea’s 2% target.

- If the exchange rate rises to 1,500 won per dollar, inflation rates are projected to increase by up to 0.24%p relative to Q1. If it falls to 1,400 won, inflation rates are projected to decrease by up to 0.44%p relative to Q1.

· If the exchange rate falls, it could exert downward pressure on consumer prices in 2026.

- With Q1 inflation rate at 2.1% and demand-side pressures remaining subdued, a rise in the exchange rate to around 1,500 won is unlikely to push the inflation rate significantly above the 2% target.

■ The finding that the impact of exchange rate fluctuations on import and consumer prices varies by underlying driver has implications for policy responses
to exchange rate volatility.

- Policy should respond to the magnitude and persistence of inflationary effects, adjusting based on the underlying driver, rather than to the exchange rate itself.

- When driven by dollar strength, the effects may be short-lived, which monetary policy should take into account.

- However, a prolonged increase in the exchange rate or growing influence of domestic factors could sustain inflationary pressures. Macroeconomic
policy should closely monitor exchange rate trends and their underlying drivers.

Summary

KDI Economic Outlook 2025-1st Half Demographic Drivers of the Propensity to Consume: Effects and Implications

■ Driven by a sharp increase in life expectancy, Korea’s average propensity to consume has declined over the past two decades, serving as a key factor behind the persistent lag in private consumption growth relative to overall economic growth.

- Despite longer life expectancy, the average retirement age from primary lifetime employment has remained largely unchanged, reinforcing precautionary saving that lowers the propensity to consume in anticipation of relatively lower and more uncertain income from secondary employment after retirement.

- The responsiveness to increased life expectancy is greater among older adults with shorter remaining life expectancy, as reflected in a marked decline in their propensity to consume.

■ Looking ahead, however, as the pace of increase in life expectancy moderates and the share of the oldest old (aged 75 and over) rises rapidly, the average propensity to consume is expected to rebound gradually.

- While life expectancy increased by approximately 6.5 years over the past two decades, it is projected to rise by only about 3.5 years over the next two decades, roughly half the previous increase.

- As low fertility persists and the share of older adults continues to rise rapidly, the working-age population is projected to contract, further dampening growth while slowly lifting the propensity to consume.

- Accordingly, the gap between private consumption growth and overall economic growth is expected to narrow gradually over time.

■ Since the two-decade decline in average propensity to consume reflects structural issues in Korea’s labor market, it is important to develop policy responses to address these challenges.

- Structural barriers to older adults' labor market participation should be removed to align retirement timing with rising life expectancy.

· The recent increase in labor market participation among some individuals in their 60s and older suggests the growing intent to remain in the workforce among older adults in response to rising life expectancy.

- To address structural barriers, policy efforts should focus on expanding labor demand for older workers by resolving labor market frictions, including reforming the seniority-based wage structure to bolster job responsibilities and performance-based pay, as well as promoting reemployment after mandatory retirement.

- Effectively leveraging the capabilities of the older workforce could help partially offset the downward pressure on potential growth resulting from low fertility and population aging.

Summary

KDI Economic Outlook 2024-2nd Half Recent Price Fluctuations: Factors and Implications

■ In the process of inflationary pressures arising from non-policy demand factors after COVID-19, model estimates suggest that fiscal policy exerted upward pressure on prices in 202223, while monetary policy has applied downward pressure since 2023.

- Rapid base rate hikes since H2 2022 have contributed to price stabilization, whereas the sustained expansive fiscal stance at a relatively high level continued to exert upward pressure through 2023.

- Although inflation begin to decelerate in 2024, the sustained high interest rate environment continues to exert downward pressure on prices.

■ With moderation in inflation expected to continue, corresponding adjustments to the macroeconomic policy stance would be advisable.

- Since the lagged effect of non-policy demand factors diminishes if no additional shocks occur, the disinflationary trend may persist in the near term.

- Therefore, the intensity of monetary tightening should be carefully calibrated to prevent inflation from remaining below the target for an extended period, and fiscal policy warrants caution considering the already elevated level of government expenditure.

Summary

KDI Economic Outlook 2024-2nd Half Medium- to Long-Term Deceleration in Private Consumption Growth: Factors and Implications

■ Real private consumption growth continues to slow alongside real economic growth. Considering other factors, recent trends suggest that the trend growth rate of real private consumption is currently in the mid-1% range.

- Given the potential growth rate near 2%, the decreased share of nominal private consumption in GDP due to increased government consumption, and the falling relative price of GDP to private consumption, sustaining the growth trend of real private consumption above the mid-1% range appears unlikely.

- Without substantial structural changes, real private consumption growth is expected to continue its downward trend along with falling potential growth.

■ Assessing recent developments from this perspective, private consumption growth appears to be converging toward its mid-to-long-term trajectory, rebounding from 0.9% in Q2 to 1.3% in Q3.

- The estimated private consumption growth rate for 2025 is in the high-1% range, below the actual rates recorded from 2017 to 2019 (2.8%) and recent potential growth (around 2%). However, as this estimate surpasses the projected trend growth, it implies easing in the private consumption slowdown.

· In 2025, potential rate cuts and export improvements may positively impact private consumption.

■ Accordingly, policy efforts should prioritize stimulating private consumption in the mid-to-long term: structural reforms to mitigate the declining potential growth rate, cautious expansion in government consumption, and strengthening export competitiveness to achieve higher value-added output.

- Over the long term, enhancing productivity is essential for bolstering economic dynamism since income constitutes the foundation of private consumption.

· The development and diffusion of production technology through R&D and education should be actively promoted, along with efforts to increase overall economic flexibility to improve resource allocation efficiency.

- Additionally, to prevent government consumption expansion from limiting private consumption capacity, it should be approached with caution, focusing on enhancing expenditure efficiency.

- Moreover, to address the trend of export prices growing more slowly than import prices, it is essential to significantly enhance the capacity for value-added export generation through advanced technological development.

Summary

KDI Economic Outlook 2024-2nd Half The Impact of Online Consumption Growth on Inflation and Employment

■ Online consumption growth positively impacts inflation by reducing supplier costs and promoting competition, but downward pressure on employment is observed over a certain period.

- As the rising share of online consumption exerts downward pressure on product prices, it is assessed to have partially contributed to stabilizing the inflationary surge immediately after the COVID-19 crisis.

- However, the transition to online spending has led to employment declines in sectors reliant on offline sales, such as wholesale and retail trade and accommodation and food services.
- While the transportation and storage sector, including delivery and logistics, experienced job creation, this only modestly offset employment declines in in-person service sectors, suggesting limited workforce mobility across industries.

■ Therefore, it is essential to foster market conditions that preserve the price-stabilizing effects of increased competition driven by advancements in e-commerce technology and online consumption growth, protecting against monopolization in related industries.

■ In the labor market, this shift is prompting cross-sectoral employment restructuring, suggesting the need for intervention through economic and social policies.

- Workers in traditional wholesale and retail sectors need policy support to expand online sales channels. In addition, stronger retraining programs are required to facilitate smoother transitions across sectors for workers in declining industries.

- Furthermore, alongside the expansion of delivery and logistics, the growing proportion of atypical employment arrangements, including workers in special employment types, calls for policy measures to build more effective social safety nets.

Summary

KDI Economic Outlook 2024-1st Half High Inflation and Consumption Stagnation: Focusing on the Relative Price between Income and Consumption

■ In South Korea, real private consumption appeared lethargic in 2023 due to the stagnation in real purchasing power, driven by a sharp rise in consumer prices (3.4%) and a decline in the real economic growth rate (1.4%).

- In both 2022 and 2023, the growth rate of real purchasing power stagnated due to falling real income relative to consumption. This slump resulted from the sharp rise in international oil prices in 2022 and the marked decline in semiconductor prices in 2023.

- Additionally, the steep upward trend in consumer prices triggered the adoption of a high-interest rate policy, further exacerbating sluggish private consumption (see Current Affairs I).

■ Going forward, the conditions for real private consumption are projected to gradually improve as the real economic growth rate expands and the value of income relative to consumption increases.

- A majority of forecasting agencies project the economic growth rate to rise to the mid-2% range in 2024, bolstered by a rapid increase in exports, higher than the 2023 figure (1.4%).

- Furthermore, in 2024, the capacity to spur private consumption is expected to experience meaningful expansion as real purchasing power substantially improves due to the marked rise in semiconductor prices.

- However, high interest rates, outside the purview of this report, are still expected to act as a delaying factor for the recovery of private consumption.

■ Therefore, it is assessed that the current situation does not require short-term macroeconomic policies to stimulate private consumption.

- Given the high probability of gradual moderation in consumption stagnation propelled by improving real purchasing power, it is not advisable to consider stimulus measures as requiring urgent action. It is also noteworthy that such policies could disrupt the ongoing trend toward inflation stabilization, potentially delaying interest rate cuts.

- In addition, given that the trends of private consumption and income eventually sync up, the policy focus should be structural reforms that improve income-generating capacity by boosting medium- to long-term economic dynamism.

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