The Bank of Korea Raises Base Interest Rate to 1.75%... Late-Year Projection at Mid-to-High 2% Range (Comprehensive Report 2)

Bank of Korea Governor Lee Chang-yong's First Monetary Policy Meeting
Base Interest Rate Raised by 0.25 Percentage Points
First Consecutive Increase in Two Months in 15 Years
Inflation Rate Forecast Also Raised to 4.5%

Lee Chang-yong, Governor of the Bank of Korea, is explaining the base interest rate hike at a press conference held at the Bank of Korea in Jung-gu, Seoul on the 26th. / Photo by Joint Press Corps

[Asia Economy Reporters Seo So-jeong and Moon Je-won] The Bank of Korea tightened monetary policy reins sharply on the 26th by raising the base interest rate and significantly upgrading this year's consumer price inflation forecast to 4.5%, the highest in 13 years and 10 months. This was an unusual move, marking the third rate hike this year and the second consecutive monthly increase following April. It clearly signaled that this stance will continue going forward. If the Bank of Korea raises rates further at the remaining monetary policy meetings this year (July, August, October, November), the year-end base rate could rise to as high as 2.75%. Even with one or two speed adjustments, it is certain to rise to the mid-2% range.

The Monetary Policy Board of the Bank of Korea held a monetary policy meeting on the day and raised the base rate by 0.25 percentage points from 1.50% to 1.75% per annum. Previously, the Monetary Policy Board signaled normalization of monetary policy by raising rates by 0.25 percentage points in August last year, and continued rate hikes consecutively in November of the same year, January this year, and again in April and May.

As inflationary pressures intensified, the Monetary Policy Board decided on an additional rate hike last month amid the unprecedented absence of a governor. At the first meeting chaired by Governor Lee Chang-yong, the Board again raised rates, tightening monetary policy reins. This marks the first time in 14 years and 9 months that the Bank of Korea has raised the base rate for two consecutive months since July and August 2007. Considering that the call rate was the policy rate at that time, this is effectively the first consecutive two-month rate hike since the base rate became the policy rate. The Bank of Korea's unusual consecutive rate hikes in April and May, following two consecutive hikes in November and January last year, reflect the rapid and widespread inflationary pressures recently.

◆4.5% Realization Would Mark Highest Inflation Rate in 14 Years= In the revised economic outlook released that day, the Bank of Korea raised the consumer price inflation forecast from the current 3.1% by 1.4 percentage points to 4.5%. This is the highest forecast since July 2008, when the consumer price inflation was projected at 4.8%, marking the highest in 13 years and 10 months. If the annual 4.5% forecast is realized, it will be the highest annual inflation rate since 2008 (4.7%) in 14 years. Next year's inflation forecast was also raised by 0.9 percentage points from 2.0% to 2.9%.

At the press conference held immediately after the Monetary Policy Board meeting, Governor Lee openly displayed a hawkish (monetary tightening preference) stance. He said, "The Statistics Korea will announce May's inflation rate in early June, and according to the Bank of Korea's estimate, it is expected to exceed 5%," emphasizing, "We will focus on inflation in operating monetary policy over the coming months." He added, "Even if oil prices fall, international grain prices tend to remain high for a considerable period once they rise, so we expect consumer price inflation to remain at 3-4% until early next year."

The reason the Bank of Korea significantly raised this year's consumer price inflation forecast is that recent inflation is spreading uncontrollably at a rapid pace. The consumer price index in April rose by 4.8% compared to the same month last year due to surging international energy prices and supply chain disruptions. This is the highest level in 13 years and 6 months since October 2008 (4.8%).

A 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, emeritus professor of economics at Yonsei University, said, "The Ukraine war has significantly raised crude oil, raw material, and grain prices, and the US interest rate hikes have pushed up the exchange rate, causing import prices to soar," emphasizing, "The Bank of Korea must raise rates to lower inflation expectations. Lowering inflation expectations is crucial to stabilizing prices."

◆Interest Rate Inversion Between Korea and the US Realized in 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 massive capital outflows, is also cited as a reason for rate hikes. With the 0.25 percentage point hike at the Monetary Policy Board meeting, the gap between Korea's base rate (1.75%) and the US rate (0.75-1.00%) widened to 0.75-1.00 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 big steps thereafter, 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 speed of US rate hikes, domestic high inflation, and the Korea-US interest rate inversion situation, 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 Board implementing big steps in the second half. Moon Hong-chul, a researcher at DB Financial Investment, said, "The Bank of Korea may raise the base rate again in July, marking three consecutive hikes, then take one or two pauses between August and November," predicting, "Still, the domestic base rate will be at least 2.25% by the end of this year." Kim Tae-gi, professor of economics at Dankook University, said, "The base rate is likely to rise to 2.5% by the second half. Since the Ukraine crisis does not seem to be resolved soon and China's 'Zero-COVID' policy is expected to continue for some time, the rapid inflation trend will likely ease only by the end of the year."

On the same day, the Bank of Korea lowered this year's real gross domestic product (GDP) growth forecast from 3.0% to the 2.7% range. Next year's growth forecast was also lowered by 0.1 percentage points from 2.5% to 2.4%. This reflects the assessment that the impact of rising raw material prices, supply chain disruptions, and China's lockdowns on the global economic slowdown 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 risky, the current inflation rate rising this much was not initially expected, so the situation is more unstable than before," adding, "It is necessary for the government and central bank to share and cooperate on economic assessments to control the situation and prevent further deterioration."