3 biggest reasons why Korea's inflation is so low

Will this trend last?

According to DBS, Korea's CPI inflation has been running at the 1% level throughout this year. This is unusually low compared to the long-term average of 3% and the central bank’s target range of 2.5%-3.5%.

There are several reasons to explain.

Here's more:

First, imported inflation has eased significantly this year thanks to the softness in global commodity prices and the strength of the KRW.

Import prices growth and the upstream producer prices growth have both fallen into the negative territory this year, the first time since 2009. Accordingly, the tradable goods prices in the CPI basket grew just 0.9% during Jan-Nov13, far lower than 3.1% last year.

Second, the government has implemented a subsidy programme on social welfares since last year, which played a large role in curbing domestic services prices. The non-tradable services items in the CPI registered an average price growth of 1.3% in Jan-Nov, close to 1.5% last year, and well below the normal level of 3%.

Third, the demand-pull inflation has been weak this year, in line with a slightly negative output gap in the domestic economy.

The labor data are puzzling, however. The jobless rate recently dropped to 2.9% in November, the lowest since 1997. We suspect that there are structural factors at play. The fall in unemployment mainly occurred among those aged 50 and above, and in the services sector. It remains premature to expect capacity tightening and a full economic recovery.

Going forward, we don’t think imported inflation will become a big problem in 2014. Commodity prices should remain subdued because of adjustments in China’s investment demand and technological advancement in global energy supply.

Meanwhile, the KRW is expected to stay firm next year, thanks to the soundness in Korea’s external position.

On the other hand, however, the domestic inflation factors are expected to change in 2014. Based on our forecast of 3.5% GDP growth for next year, the output gap will be closed in 2H14, the labor market will be tightened then and the demand-side price pressures will start to build.

We project that inflation will average 2.4% next year, exceeding 2.5% in 2H14. This should set the stage for the Bank of Korea to raise interest rates from 3Q14.