An anti-Iranian demonstration is held outside the Iranian Embassy in London, Sunday (local time), as Iran's Revolutionary Guards Corps announced that they had launched "dozens of drones and missiles" toward military sites on Israeli territory. AFP-Yonhap

The latest developments occurring in the Middle East between Iran and Israel are feared to worsen inflation, significantly disrupting the Korean economy, which is heavily dependent on oil imports from the region. It is suggested that the combination of high inflation, high interest rates and high exchange rates will act as a drag on Korea for some time.

On Monday, the won-dollar exchange rate opened at 1,382 won per dollar, up 6.6 won from the previous day. This increase is attributed to a series of factors, including geopolitical instability in the Middle East and favorable economic conditions in the U.S.

The won-dollar exchange rate has exceeded the 1,375-won threshold only during the Asian financial crisis in 1997, the global financial crisis in 2008, and the intense dollar strengthening witnessed in 2022 due to the U.S.' aggressive monetary tightening.

Bank of Korea (BOK) Senior Deputy Governor Ryoo Sang-dai noted that the ongoing crisis in the Middle East could lead to heightened volatility in the domestic market.

"Fluctuations in international oil prices, exchange rates and shifts in the global supply chain may further increase uncertainties in the real economy, impacting both growth and inflation rates worldwide," Ryoo said during an emergency meeting, Monday.

As the plummeting value of the Korean won could push up import prices, high inflation is expected to continue to loom in Korea for some time.

The biggest fear is how high global oil prices might rise. Some suggest that oil prices could escalate to as much as $130 per barrel if the Strait of Hormuz is blocked and regional tensions intensify. They already reached the $90 level on Friday (local time) on the New York Mercantile Exchange.

Korea's total dependence on imported oil makes the country particularly vulnerable to instability in the Middle East.

Finance Minister Choi Sang-mok convenes a meeting at the Government Complex in Seoul, Monday, announcing the extension of a fuel tax cut for an additional two months. Yonhap

The recent rebound in the country's inflation level to approximately 3 percent was also driven by rising prices of petroleum products and fruit. Last month, petroleum prices increased by 1.2 percent compared to the previous year.

In response, on Monday, the finance ministry announced that it would extend the fuel tax cut for two additional months. The 25 percent discount on gasoline and 37 percent discount on diesel and liquefied petroleum gas were supposed to expire at the end of this month.

Nevertheless, the public burden is likely to intensify, as there are high chances of increases in the prices of food and utilities now that the general elections have ended. The government had artificially suppressed food prices and delayed discussions on utility hikes up until the elections, because such hikes would impact negatively on the ruling bloc.

"The burden is intensifying due to rising raw material prices, including oil prices," a food industry official said. "We are closely monitoring the situation while developing response measures."

While the BOK has identified price stabilization as a crucial precondition for any reduction in interest rates, market sentiment suggests that the likelihood of a rate cut in the third quarter is fading.

Market watchers believe that the potential for further escalation of economic instability hinges on Israel's response.

Shinhan Securities analyst Ha Keon-hyeong estimated that if the conflict can be quickly resolved, international oil prices could fall to $80 per barrel, reducing the upward risk of inflation. This could potentially allow major central banks to swiftly shift toward monetary easing.

However, in the event of a full-scale conflict between Iran and Israel, advanced nations may consider further tightening measures to control inflation, thereby prolonging the period of high interest rates.