"If US Raises Interest Rates, Korea's Base Rate Hits 2.86%...Households Pay 3.45 Million Won More Annually in Interest"

Estimated US Appropriate Benchmark Interest Rate at 2.33% This Year

[Asia Economy Reporter Kim Jin-ho] Regarding the U.S. Federal Open Market Committee (FOMC) signaling steep interest rate hikes this year, including a big step (a 0.5 percentage point increase in the benchmark interest rate at once) next month, an analysis has emerged predicting that South Korea's benchmark interest rate will also rise rapidly in tandem.

According to the analysis report titled "Estimation of Appropriate Benchmark Interest Rates in the U.S. and South Korea and Its Implications," released on the 14th by the Korea Economic Research Institute (KERI) under the Federation of Korean Industries, the appropriate benchmark interest rate for the U.S. this year is estimated at 2.33%. KERI forecasted that if South Korea follows the U.S. rate hikes, the domestic benchmark interest rate could rise to 2.86%. The Bank of Korea held a Monetary Policy Committee meeting on the same day and raised the benchmark interest rate by 0.25 percentage points. As a result, the domestic benchmark interest rate stands at 1.5%.

KERI explained that despite economic uncertainties such as Russia's invasion of Ukraine, the U.S. is considering a big step of raising the benchmark interest rate by 0.5 percentage points in May following the March rate hike because inflation is accelerating too rapidly while real economy fundamentals like employment remain solid.

In fact, the U.S. consumer price inflation rate in March this year was 8.5%, the highest in 41 years since December 1981's 8.9%. Meanwhile, the unemployment rate in March fell to 3.6%, and the GDP growth rate for the fourth quarter of last year recorded a robust 7.0% increase.

KERI set up a model explaining the U.S. benchmark interest rate using economic variables such as the U.S. inflation rate (year-on-year consumer price inflation), unemployment rate, and money supply (M1), and estimated that the appropriate benchmark interest rate for the U.S. this year is 2.33%, according to their analysis.

KERI stated, "As of April, the U.S. benchmark interest rate level is 0.375% (ranging from 0.25% to 0.5%), so to reach the appropriate benchmark interest rate level, an increase of 1.95 percentage points is necessary," adding, "Since the U.S. Federal Reserve has started raising the benchmark interest rate, the upward trend will continue until it reaches at least the appropriate level."

Based on this estimate, KERI calculated the appropriate increase in South Korea's benchmark interest rate if the U.S. Federal Reserve raises its benchmark interest rate to the appropriate level of 2.33%.

First, assuming the Korean won exchange rate remains stable (expected exchange rate depreciation rate of 0%), if the U.S. benchmark interest rate reaches 2.33% and South Korea's benchmark interest rate remains at the current level of 1.25%, the interest rate gap between Korea and the U.S. would widen to 1.08 percentage points, causing an interest rate inversion. To secure the appropriate benchmark interest rate difference of 0.53 percentage points, the Bank of Korea is estimated to raise the rate by 1.61 percentage points.

In other words, the appropriate benchmark interest rate in South Korea, following the U.S. rate hikes, is expected to rise from the current 1.25% by 1.61 percentage points to 2.86%.

The problem is that under these assumptions, the burden of household debt, the biggest risk factor for the Korean economy, would increase significantly. According to KERI's calculations, if South Korea's benchmark interest rate rises by 1.61 percentage points, household loan interest rates would increase by 1.90 percentage points. The annual increase in household loan interest burden due to the rate hike is estimated at 40.3 trillion won. On a per household basis, this means an increase in interest burden of 3.45 million won.

Choo Kwang-ho, head of KERI's Economic Policy Office, said, "With the U.S. aggressively signaling interest rate hikes, South Korea's rate hikes have become inevitable. Therefore, efforts should be made to enhance the financial resilience of households and the private sector through private job creation and to minimize the extent of rate hikes." He added, "Among the variables affecting the appropriate increase in South Korea's benchmark interest rate, the U.S. benchmark interest rate level is the most important. However, the government must also take steps to stabilize the won's value, improve corporate competitiveness, stabilize raw material supply, turn the trade balance into surplus, and stabilize the foreign exchange market."