[Q&A] Lee Chang-yong: "Inflation Has Significant Negative Spillover Effects"... Indicates Consecutive Interest Rate Hikes

BoK Raises May Base Rate from 1.5% to 1.75%
Vulnerable Groups Face Increased Burden, Urgent Inflation Response Needed

Bank of Korea Governor Lee Chang-yong is explaining the results of the Monetary Policy Committee meeting held on the 26th at the Bank of Korea briefing room in Jung-gu, Seoul.
[Photo by Yonhap News]

Lee Chang-yong, Governor of the Bank of Korea, on the 26th regarding the Monetary Policy Committee's (MPC) decision to raise the base interest rate by 0.25 percentage points, stated, "Since the negative ripple effects of inflation are expected to be greater, it is necessary to respond proactively," adding, "Although there are concerns that the burden on vulnerable groups may increase, if inflation expectations spread in the current situation, the damage could be even greater."

Governor Lee made these remarks during a press conference held immediately after the regular MPC meeting at the Bank of Korea in Jung-gu, Seoul. Regarding the market's expectation that the year-end base interest rate will rise to 2.25~2.5%, he said, "I think it is reasonable given that inflation has risen more than expected," and emphasized, "it is necessary to operate monetary policy with a greater focus on inflation for the time being."

Regarding future inflation forecasts, he said, "although Statistics Korea will announce the data, we expect the inflation rate in May to exceed 5%," adding, "even in March, we predicted inflation this year would be 'high in the first half and low in the second half,' but looking at the current trend, we cannot rule out the possibility that the peak will be after the middle of the first half rather than in the first half itself."

However, Governor Lee viewed the possibility of a 'big step' (a 0.5 percentage point increase in the base interest rate at once) or stagflation (economic stagnation amid rising inflation) as low. He said, "At this point, rather than worrying about stagflation, we should be more concerned about inflation," and added, "Mentioning a big step was a fundamental statement that, given the uncertainty of various indicators, all possibilities should be kept open and considered."

Below is a Q&A with Governor Lee

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

- The inflation forecast for this year is quite high. Until now, the Bank of Korea's stance was that interest rate hikes above the neutral rate were unnecessary. Is there no change in this stance even with inflation this high? Please also explain your judgment on the neutral interest rate level. You mentioned operating monetary policy with a focus on inflation for the time being; if 'for the time being' is interpreted as about 3-4 months, does this imply consecutive rate hikes in July and August?

▲It is clear that the current real interest rate is below the neutral rate. Our priority is to bring the current interest rate level to the neutral rate. In the process of raising rates based on new data, we need to assess the impact on growth and decide whether to go above the neutral rate or not.

There have been multiple discussions on whether it is good to announce the neutral rate level, but statistically, the neutral rate varies greatly depending on the research. If the Bank of Korea mentions the neutral rate, it could be interpreted as a definitive indicator of a rate hike, so there are differing opinions among MPC members, and discussions are ongoing.

Also, interpreting 'for the time being' as 'several months' aligns with our intention. However, it is not appropriate for me to explicitly specify the timing of rate adjustments. Statistics Korea is scheduled to announce the May inflation rate in early June, and we believe there is a high possibility it will exceed 5%. GDP data will be released in July, and importantly, the Federal Reserve's interest rate decisions in June will be crucial data. Therefore, we will decide how rates move in July and August based on the data that comes out.

- Even if Korea raises the base rate three consecutive times by July, if the Fed makes two more big steps, the base rate will reach the same level as Korea's. Is the possibility of a big step still open at the Bank of Korea?

▲ My mention of a big step was a fundamental statement that, given the current high uncertainty in various economic indicators, all possibilities should be kept open and considered when operating Korea's monetary policy. It is nothing more or less than that. I hope it is not interpreted as a plan to make a big step at a specific time.

- When do you think Korea's inflation rate will peak? Also, how long do you expect inflation above 2% to persist?

▲ Assuming oil prices at $107 per barrel will fall to $99 by year-end and to the mid-$90s next year, and that the Ukraine crisis and global supply disruptions will normalize by year-end, it is certain that the May inflation rate will exceed 5%. When we made predictions in March, we expected a 'high first half and low second half,' but looking at the current trend, we cannot exclude the possibility that the peak will be after the middle of the first half. Even if oil prices fall, international grain prices have risen significantly, so we expect inflation to remain in the 4% range for a considerable period next year before declining.

- The market has raised its year-end base rate forecast from 2.0% to about 2.5%. Do you consider this a reasonable level?

▲ Since inflation has risen more than expected, I think it is reasonable that the market's expected interest rate level has increased. Compared to February, inflation expectations have risen by more than 1%, so the market's expectation of a base rate of 2.25~2.5% is reasonable.

Lee Chang-yong, Governor of the Bank of Korea, is seen deep in thought while listening to questions from reporters after explaining the results of the Monetary Policy Committee meeting held on the 26th at the Bank of Korea briefing room in Jung-gu, Seoul.
[Photo by Yonhap News]

- There are concerns about stagflation. Do you think Korea's economic conditions allow for raising rates to combat inflation at the expense of growth, as seen in the US or UK?

▲ While inflation has upward pressure and the economy is slowing, growth rates of 2.7% and 2.4% are still above potential growth, so I think we should be more concerned about inflationary pressures than stagflation at this point.

- The joint statement from the Korea-US summit mentioned cooperation in the foreign exchange market. Are there any practical plans underway?

▲ The negotiations on the foreign exchange market situation mentioned during President Biden's visit were led by the Ministry of Economy and Finance and the US Treasury Department. It is not appropriate for me to disclose details of those negotiations. However, in a broader sense, the two leaders' remarks reflect that foreign exchange market stability is an important factor for bilateral trade and investment within the framework of the strategic agreement between Korea and the US, which is quite meaningful.

- There are concerns that the Bank of Korea's rate hikes could slow the economy or increase interest burdens on vulnerable groups. What is your view?

▲ It is the right direction to respond proactively to prevent rising inflation from triggering higher inflation expectations and greater risks, but in the process, higher rates do have a greater impact on some parts. In particular, Korea's recovery is characterized by polarization, with large corporations and IT industries doing well, but traditional sectors recovering slowly.

Specifically, we estimate that every 0.25 percentage point increase in rates raises household interest costs by over 3 trillion won and corporate burdens by 2.7 trillion won. Among these, the damage to small and medium-sized enterprises and self-employed individuals requires policy responses. Since monetary policy alone has limitations, cooperation with the government is necessary.

- You mentioned that the interest rate differential between Korea and the US is difficult to use as a primary criterion for monetary policy and can be tolerated for a certain period. Is this still your position?

▲ It is natural that our rates are generally higher than the US, but in terms of short-term rates, there is no rule that the Korea-US rate differential must never invert. Currently, US inflation exceeds 8%, and the US economy is growing robustly compared to Korea. It is natural for the US to raise rates faster. We consider that capital outflows or exchange rate issues caused by rate inversion are manageable under Korea's current situation.

- You mentioned supplementary budgets and private consumption as upward factors. What kind of ripple effects do you expect?

▲ The supplementary budget is estimated to raise our economic growth by about 0.2~0.3% and affect inflation by about 0.1%. However, the supplementary budget is a pledge and temporary support for the self-employed, so it is unavoidable. We consider this when deciding rates. According to our model, a 0.25 percentage point rate hike reduces inflation by about 0.1% over two years. Including today, we have raised rates five times in the past eight months, so the cumulative effect on inflation is about 0.5%. This is not a small amount. We operate policy with a greater focus on the impact of rates on inflation.