[Seungseop Song's Financial Light] How Is the Base Interest Rate Determined?

Base Interest Rate Rises 0.25%P to 1.25%
Decided by Bank of Korea Monetary Policy Committee
Assessed 8 Times a Year Based on Economic Conditions
Growth, Inflation, Exchange Rate, and Loans Are Variables

Finance is difficult. It is filled with confusing terms and complex backstories intertwined. Sometimes, you need to learn dozens of concepts just to understand a single word. Yet, finance is important. To understand the philosophy of fund management and to consistently follow the flow of money, basic financial knowledge must be the foundation. Therefore, Asia Economy selects one financial issue each week and explains it in very simple terms. Even if you know nothing about finance, you can immediately understand these ‘light’ stories that turn on the bright ‘light’ of finance for you.

The Monetary Policy Committee plenary meeting held on the 14th at the Bank of Korea in Jung-gu, Seoul. [Image source=Yonhap News]

[Asia Economy Reporter Song Seungseop] The base interest rate has risen by 0.25 percentage points. Now, Korea’s base interest rate is 1.25%, returning to the pre-COVID-19 level. There are various opinions about the background and aftermath of the decision to raise the base interest rate. This is because its impact on our economy is significant. Who decides this base interest rate, how is it decided, and what ripple effects does it bring?

The base interest rate is the policy rate set by the central bank, the Bank of Korea, as a benchmark when dealing with other financial institutions. Just as individuals or companies borrow money from banks, banks also borrow funds from the Bank of Korea when they need money. The Bank of Korea is the ‘bank of banks.’ Among these transactions, there are times when banks need to borrow money for a short period, and the interest rate applied by the Bank of Korea at that time is the base interest rate.

This base interest rate can go up or down depending on the situation. It can also be decided to ‘stay the same.’ The Monetary Policy Committee within the Bank of Korea decides the base interest rate eight times a year. The Monetary Policy Committee consists of seven members appointed by the president. When it is time to decide the base interest rate, these seven members receive various reports related to Korea’s economy. Then, the members discuss how to set the base interest rate and each expresses their opinion (increase, hold, or decrease).

Governor Lee Ju-yeol of the Bank of Korea speaking at the monetary policy direction press conference on the 14th.
[Image source=Yonhap News]

What happens to our economy when the base interest rate rises or falls? When the base interest rate becomes cheaper, it means banks can borrow money from the Bank of Korea at a lower interest rate. Banks can then lend this borrowed money to companies and individuals at a cheaper rate. Various economic agents will find it easier to invest or consume, and the economy will grow faster. This is why the Bank of Korea lowers the base interest rate during recessions.

However, lowering the base interest rate is not always good. When the base interest rate is lowered, inflation occurs, causing prices to rise. If cheap funds are used to invest in real estate or stocks, real estate prices rise excessively, and the stock market overheats. If loans increase too much, the interest burden on households and companies will become heavy.

Raising the base interest rate has the opposite effect. Since banks have to borrow money from the Bank of Korea at a higher cost, households and companies find it harder to get loans easily. They tend to save rather than spend. Consumption decreases, and economic activity slows down. However, this can stabilize or reduce the previously soaring inflation.

The base interest rate will rise again

Let’s look at a report released by the Bank of Korea. The Bank of Korea explained the reason for raising the interest rate from 0.75% to 1.00% last November as follows.

“The consumer price inflation rate continued at a high level in the mid-2% range as the rise in petroleum products and service prices expanded, and it was expected to remain at the mid-2% range for some time. From the financial stability perspective, housing prices continued to rise sharply in both the metropolitan area and provinces, while household loans, mainly housing-related loans, also continued to increase significantly.”

“While the sharp rise in housing prices continued, the increase in household loans somewhat slowed, but the risk of accumulated financial imbalance remains high. Accordingly, the Bank of Korea decided to raise the base interest rate by an additional 0.25 percentage points following August and to operate monetary policy by appropriately reducing the degree of easing in line with economic improvement and financial imbalance situations.”

Loan information banner posted at a bank in downtown Seoul on the 14th, when the base interest rate hike was announced [Image source=Yonhap News]

At that time, the explanation was that the inflation rate was high and needed to be lowered. The Bank of Korea considers the inflation stabilization target to be 2%, but the report states that inflation was in the ‘mid-2% range.’ It also notes that housing prices were continuously rising and loan growth was steep. Therefore, it says the interest rate was raised to lower inflation and curb loan growth.

The base interest rate is expected to rise further in the future. Considering various situations, the rate is still low. On the 14th, right after raising the base interest rate, Bank of Korea Governor Lee Ju-yeol held a non-face-to-face press conference and said, “Considering growth, inflation, and outlook, it is still judged to be a relatively accommodative level compared to the real economy.” He emphasized, “It is necessary to adjust the base interest rate further according to the economic situation.”