Bank of Korea Raises Inflation Forecast Sharply... Year-End Interest Rate Likely to Exceed Mid-2% Range (Comprehensive)

This Year's Inflation Rate Forecast at 4.5%
Possibility of Interest Rate Inversion Between Korea and the US Increases
Interest Rate Hike Trend Likely to Continue

[Asia Economy Reporters Seo So-jeong and Moon Je-won] Lee Chang-yong, Governor of the Bank of Korea, boldly revealed his hawkish (preference for monetary tightening) stance by sharply raising this year's consumer price inflation forecast to 4.5%. If the annual 4.5% forecast is realized, it will mark the highest annual inflation rate in 14 years since 2008 (4.7%). This judgment is based on the expectation that the surge in prices caused by the Russia-Ukraine war, which has led to a sharp rise in international raw material prices and supply chain disruptions, will continue into next year. The inflation forecast for next year was also raised by 0.9 percentage points from 2.0% to 2.9%.

◆ Highest inflation rate in 14 years if 4.5% is realized = The reason the Bank of Korea significantly raised this year's consumer price inflation forecast is that inflation is spreading at an uncontrollable pace recently. The consumer price index in April rose by 4.8% compared to the same month last year, influenced by the sharp rise in international energy prices and supply chain disruptions. This is the highest level in 13 years and 6 months since October 2008 (4.8%).

The bigger problem is that economic agents expect prices to rise further. According to the Bank of Korea's consumer sentiment survey, the expected inflation rate in May was 3.3%, the highest in 9 years and 7 months since October 2012 (3.3%). Kim Jeong-sik, Professor Emeritus of Economics at Yonsei University, said, "Due to the Ukraine war, crude oil, raw materials, and grain prices have risen sharply, and the US interest rate hikes have increased the exchange rate, causing import prices to soar," adding, "The Bank of Korea needs to raise interest rates to lower inflation expectations," emphasizing, "Lowering inflation expectations is crucial to stabilizing prices."

Bank of Korea Governor Lee Chang-yong is striking the gavel at the Monetary Policy Committee meeting held on the 26th at the Bank of Korea in Jung-gu, Seoul. Photo by Joint Press Corps

◆ Interest rate inversion between Korea and the US likely in the second half = With the US Federal Reserve (Fed) signaling additional big steps (0.5% hikes at once), the possibility of interest rate inversion between Korea and the US in the second half, which could lead to large-scale capital outflows, is also cited as a reason for raising interest rates. On this day, the Monetary Policy Committee raised the interest rate by 0.25 percentage points, making the benchmark interest rate gap between Korea (1.75%) and the US (0.75~1.00%) between 0.75 and 1.00 percentage points. If the Fed raises rates by 0.5 percentage points at the Federal Open Market Committee (FOMC) meeting on June 14-15 and continues with further big steps, interest rate inversion in the second half could become a reality.

For the Korean won, which is not a key currency like the dollar, if interest rates invert or narrow, foreign investor capital may flow out, and the resulting sharp rise in the won-dollar exchange rate could fuel inflation. Sung Tae-yoon, Professor of Economics at Yonsei University, said, "Considering the pace of US rate hikes, domestic high inflation, and the interest rate inversion between Korea and the US, this month's rate hike was an inevitable choice," adding, "Gradual and continuous rate hikes should continue going forward."

However, experts see a low possibility of the Monetary Policy Committee implementing a big step in the second half. Moon Hong-chul, a researcher at DB Financial Investment, said, "The Bank of Korea may raise the benchmark interest rate again in July for the third consecutive hike, then take a breather one or two times between August and November," predicting, "Still, the domestic benchmark interest rate will be at least 2.25% by the end of this year." Kim Tae-gi, Professor of Economics at Dankook University, said, "The benchmark interest rate is likely to rise to 2.5% by the second half," adding, "Since the Ukraine crisis does not seem to be resolved soon and China's 'Zero-COVID' policy is expected to continue for a while, the rapid inflation trend will likely ease only by the end of the year."

On this day, the Bank of Korea lowered its real Gross Domestic Product (GDP) growth forecast for this year from 3.0% to the 2.7% range. The growth forecast for next year was also lowered by 0.1 percentage points from 2.5% to 2.4%. This reflects the judgment that the impact of rising raw material prices, supply chain disruptions, and China's lockdowns on the global economy will continue into next year. Kim Jin-il, Professor of Economics at Korea University, said, "While the Korean economy is not yet at a level considered dangerous, the current inflation rate rising this much was not initially expected, so it is indeed a more unstable situation than before," adding, "It is necessary for the government and the central bank to share and cooperate in recognizing the economic situation to control it from worsening further."