[Base Rate 3%] House Prices and Growth Rate Will Fall Further... Bank of Korea "Will Continue Rate Hike Stance" (Comprehensive)

2.5%P Increase Since Last August Lowers Inflation by 1%P
Big Step Raises Household and Corporate Interest Burden by 12.2 Trillion Won
Sharp Won Depreciation Justifies Big Step
November Rate Hike to Be Decided After US FOMC
Many Monetary Policy Committee Members Say "Final Rate Around 3.5%"

Lee Chang-yong, Governor of the Bank of Korea, is presiding over the regular Monetary Policy Committee meeting held on the 12th at the Bank of Korea in Jung-gu, Seoul. Photo by Joint Press Corps

[Asia Economy Reporter Seo So-jeong] Lee Chang-yong, Governor of the Bank of Korea, predicted that the 2.50 percentage point increase in the base interest rate since August last year would reduce the inflation rate by more than 1 percentage point. However, the big step (a 0.5 percentage point increase in the base rate at once) implemented again after three months is estimated to lower the economic growth rate by around 0.1 percentage points. He also warned of further declines in housing prices due to the interest rate hikes.

Governor Lee Chang-yong stated at a press conference held after the Bank of Korea's Monetary Policy Board meeting on the 12th, "Since August last year, the interest rate has risen by 2.5 percentage points, but there is a time lag in its effect on inflation," adding, "According to econometric models, the inflation rate is expected to decrease by about 1 percentage point until the first half of next year."

He also projected that the interest burden on households and businesses would increase by about 12.2 trillion won due to this big step, and the growth rate of household debt would slow down by about 1%.

◆High exchange rate adds upward pressure on inflation... Minority opinion for baby step= The Bank of Korea's Monetary Policy Board held a monetary policy direction meeting on the morning of the same day and raised the base interest rate from 2.5% to 3.00%. This year, the Bank of Korea raised the base rate by 0.25 percentage points each in January and April, and in July, it implemented the first-ever big step by raising it by 0.50 percentage points. Subsequently, it raised the rate by 0.25 percentage points in August and took the second big step on this day, returning to the 3.00% level last seen in October 2012.

In the monetary policy direction statement, the Monetary Policy Board forecasted that consumer prices would continue to rise at a high rate of 5-6% for a considerable period due to upward pressure from exchange rate increases and other factors. The consumer price inflation rates for this year and next are expected to generally align with the August projections (5.2% and 3.7%, respectively), but despite downward pressure from economic slowdown, upward risks remain significant due to exchange rate increases and production cuts by major oil-producing countries.

The economic growth rate is expected to meet the August forecast of 2.6% for this year but fall short of the 2.1% forecast for next year. Regarding the possibility of next year's growth rate falling below 2%, Governor Lee said, "The Bank of Korea's new forecast will be released in November, so we need to look at the data," adding, "Since the base rate has risen by 0.50 percentage points, growth is expected to decline due to external conditions and the effect of rate hikes, but I am not sure if it will fall below 2%."

Governor Lee explained the background of the big step, saying, "Although next year's growth rate is expected to be lower than initially forecast, inflation is projected to remain at a high level of 5-6% for a considerable period. Given the additional upward risk from exchange rate increases and the fact that expectations of exchange rate rises increase capital outflow pressure and cause market concentration in the foreign exchange market, which partly contributes to financial instability, it was judged necessary to strengthen policy responses." Regarding this decision, Monetary Policy Board members Joo Sang-young and Shin Sung-hwan expressed minority opinions favoring a 0.25 percentage point increase in the base rate.

[Image source=Yonhap News]

The sharp depreciation of the Korean won in September also served as a major basis for the big step. Governor Lee said, "If the won depreciates sharply, it raises import prices and affects the inflation rate," adding, "The risk of significantly delaying the decline in inflation has increased, so we are responding accordingly." He also noted, "If the interest rate gap between Korea and the U.S. widens, the scale of foreign currency outflows may increase, and as the exchange rate rises, margin calls (requests for additional collateral due to asset value declines) could pressure foreign currency liquidity, transmitting effects to the domestic financial market. Therefore, the majority opinion among Monetary Policy Board members was that the big step is more appropriate."

Furthermore, amid concerns about the rise in the won-dollar exchange rate, Governor Lee urged looking at changes in other countries' currency values rather than focusing solely on the extent of the won's rise. He emphasized, "We should not compare the absolute level of the exchange rate but consider the degree to which other countries' exchange rates are moving together," adding, "It is not appropriate to ignore this and compare the current situation with past crises such as those in 1997 or 2008, given the strong dollar and changes in all other currencies."

◆Uncertainty over November rate hike size... Final rate expected around 3.5%= Regarding the November Monetary Policy Board meeting, Governor Lee indicated a cautious stance on the size of the rate hike while maintaining the rate hike trend. He explained, "There is significant uncertainty about the policy environment and diverse views among board members regarding the size of the November hike. We will carefully review changes in external conditions such as the U.S. Federal Reserve's November Federal Open Market Committee (FOMC) meeting and international energy price movements, as well as their impact on domestic inflation, growth trends, and financial and foreign exchange markets, before making a decision."

Regarding market expectations that the base rate peak will be around 3.5% in the current rate cycle, Governor Lee said, "Most board members have similar views, though some see it lower," adding, "It does not mean that the hike will stop exactly at 3.5%, but many members think it will be around that level."

On the impact of rate hikes on the real estate market, Governor Lee said, "Various indicators show that actual transaction prices have fallen by about 3-4% from January to August this year," and predicted, "Since interest rates are rising like this, there is a possibility of further declines."

He added, "The significant rise in real estate prices and increase in household debt over the past two to three years were major causes of financial instability," and said, "While the adjustment of real estate prices and household debt growth through this rate hike is painful and regrettable, I believe it also contributes to overall macroeconomic stability."