Six Consecutive Rate Hikes to 3.25%... 'Baby Step' Amid Funding Squeeze Concerns (Comprehensive)

BoK Unanimously Raises Base Rate by 0.25%P
Expectations for Weaker US Monetary Tightening
Domestic Fund Market Volatility Including Bonds
Growth Forecast Lowered to 1.7% for Next Year
Growth Rate Falls Below 2% for First Time in 13 Years
"Weakened Growth Due to Export Decline"

[Image source=Yonhap News]

[Asia Economy reporters Seo So-jeong and Moon Je-won] The Bank of Korea (BOK) on the 24th sharply lowered its economic growth forecast for next year to 1.7%, signaling a recession. This is a 0.4 percentage point cut from the 2.1% forecast released in August and is below the potential growth rate (2%). Reflecting these downside risks to the economy, the BOK raised the base interest rate by 0.25 percentage points to 3.25% on the same day, adjusting the pace of tightening.

The Monetary Policy Board of the Bank of Korea raised the base interest rate from the current 3.00% to 3.25% by 0.25 percentage points at the monetary policy meeting held from 9 a.m. that day. The board had consecutively raised the base rate in April, May, July, August, and October meetings this year, and with this last meeting of the year, it set a record for the first-ever six consecutive rate hikes.

The rate hike was continued to narrow the interest rate gap with the United States, which had widened up to 1 percentage point due to the U.S. Federal Reserve’s (Fed) four consecutive giant steps (0.75 percentage point hikes) amid persistent consumer price inflation above 5%. This year, the base rate was raised by 0.25 percentage points each in January, April, and May; 0.50 percentage points in July; 0.25 percentage points in August; 0.50 percentage points in October; and with this additional hike, the rate returned to 3.25% for the first time in 10 years and 4 months since July 2012. The BOK’s decision to slow the pace with a baby step (0.25 percentage point hike) this time reflects growing expectations that the U.S. monetary tightening will ease amid the recent global economic slowdown and the ongoing instability in domestic capital markets such as the bond market following the Legoland incident.

Although the high inflation rate above 5% remains a burden, the recent stabilization of the won-dollar exchange rate and international oil prices, along with a slight decline in the expected inflation rate for the next year to 4.2% from 4.3% last month, led the BOK to place more emphasis on economic sluggishness and financial stability in its monetary policy decision. Governor Lee Chang-yong said, "A 0.25 percentage point hike is appropriate considering the expected greater economic slowdown compared to the August forecast, the easing of foreign exchange risks, and the contraction of the short-term financial market." He added, "The Monetary Policy Board will continue to monitor growth while operating monetary policy to stabilize inflation at the target level in the medium term and pay attention to financial stability."

◆ Next Year’s Growth Forecast Lowered by 0.4 Percentage Points to 1.7% = In the revised economic outlook released that day, the BOK lowered the growth forecast for next year to 1.7%. This is the first time in 12 years and 11 months since December 2009 (0.2%), excluding the COVID-19 period, that the BOK has forecast economic growth below 2%. The BOK’s forecast is lower than most institutions such as the Asian Development Bank (ADB, 2.3%), International Monetary Fund (IMF, 2.0%), credit rating agency Fitch (1.9%), Organisation for Economic Co-operation and Development (OECD, 1.8%), and Korea Development Institute (KDI, 1.8%), and is the same as the Korea Institute of Finance (1.7%). The BOK also lowered its consumer price inflation forecast for next year slightly from 3.7% to 3.6%. Governor Lee said, "Domestic consumption continued to recover, but exports turned to decline, and the growth slowdown continued. Going forward, the domestic economy is expected to weaken due to the global economic slowdown and rising interest rates."

With the BOK lowering the economic growth forecast to the 1% range, attention is focused on the impact on future monetary policy. The prolonged Ukraine crisis and interest rate hikes by major countries have expanded the export slowdown, weakening growth momentum. The ongoing tight monetary policy to combat high inflation has accumulated fatigue over rate hikes, which could lead to reduced investment and consumption, supporting calls for a slowdown in tightening. Kim Jun-il, visiting professor at Yonsei University Graduate School of International Studies, said, "It usually takes about three quarters for a base rate hike to directly affect the real economy. Since the effects of the current tight monetary policy will fully materialize from the first half of next year, the economy will inevitably face more difficulties."

However, despite recent expectations for a slowdown in the Fed’s tightening pace, hawkish remarks from key officials have raised expectations for a higher terminal rate in the U.S., which remains a variable. Although the BOK narrowed the interest rate gap with the U.S. to 0.75 percentage points by raising the base rate by 0.25 percentage points, if the Fed takes at least a big step (0.50 percentage point hike) next month, the gap will widen again to 1.25 percentage points. A further widening of the Korea-U.S. interest rate gap could increase capital outflow concerns and cause the recently stabilized won-dollar exchange rate to surge.

◆ Inflation Above 5% and Household Interest Burden = Inflation remaining above 5% is also complicating monetary policy decisions. The consumer price index (CPI) in October was 109.21, up 5.7% from the same month last year. Although the inflation rate peaked at 6.3% in July and fell to 5.7% in August and 5.6% in September, it rose again after three months.

The record six consecutive rate hikes have significantly increased household interest burdens, adding weight to calls for a slowdown. Mortgage loan rates have already approached 8%, and credit loan rates exceed 6%, so the BOK’s decision will inevitably push commercial bank loan rates higher. Experts warn that the high interest rate effect is likely to continue at least until next year, urging caution over expanding credit risks.

According to the financial sector, with the BOK’s 0.25 percentage point hike, pressure for further increases in mortgage and credit loan rates at commercial banks is expected to grow. Currently, the variable-rate mortgage loan rates at the five major commercial banks (KB Kookmin, Shinhan, Hana, Woori, NH Nonghyup) range from 5.70% to 7.83%, with the upper bound nearing 8%, and the average credit loan rate has surpassed 6%. The COFIX (Cost of Funds Index), a benchmark for interest rate calculation, hit a record high last month. Despite continued rate hikes, household loans decreased by 300 billion won in the third quarter compared to the previous quarter, but mortgage loan balances increased by 6.5 trillion won, reaching a record high of 1,007.9 trillion won, acting as a time bomb for household debt.

If someone borrowed 400 million won at a 4% variable interest rate (30-year maturity, equal principal and interest repayment) before last year’s rate hikes, the initial monthly interest burden was about 1.3 million won. If the rate rises to 8%, it jumps to 2.6 million won. Considering principal repayment, the monthly payment approaches 3 million won.

Industry analysts say that since the U.S. rate hike trend continues, mortgage rates could reach 10% next year, increasing repayment burdens further. According to the BOK, a 0.25 percentage point hike in the base rate increases the total interest burden of all borrowers by about 3.3 trillion won annually. Considering the total 2.75 percentage point increase in the base rate over nine hikes since August last year, household interest payments have increased by about 38 trillion won over one year and three months, averaging 1.8 million won per borrower annually. Ko Jong-wan, president of the Korea Asset Management Corporation, said, "The effects of rate hikes last for two to three years, so multi-homeowners with high interest burdens need to downsize. For single-homeowners, it is better to endure due to high rent burdens, but depending on loans and regions, disposal should also be considered."

◆ Will the Terminal Rate Be Raised to 3.75%? = With the BOK slowing the pace with a baby step this month, market attention is turning to the terminal rate. Experts expect the rate hike trend to continue until the first half of next year, forecasting a terminal rate between 3.50% and 3.75%. Park Seok-gil, economist at JP Morgan, said, "With rising expectations for the Fed’s terminal rate, the BOK is also likely to raise its terminal rate from the previous 3.5% to 3.75%. The key issue is how long the BOK will maintain the terminal rate amid economic slowdown." Kang Sam-mo, professor of economics at Dongguk University, said, "Since there is no clear signal that U.S. inflation has been fully controlled, the U.S. is expected to continue raising rates next year, widening the Korea-U.S. interest rate gap further. While a gap of 1 to 1.25 percentage points is manageable, a gap of 1.5 to 1.75 percentage points could be difficult to handle."

Regarding the terminal rate, Governor Lee said, "Opinions among Monetary Policy Board members were divided. Three members favored a terminal rate of 3.5%, one member preferred to stop at 3.25%, and two members left open the possibility of raising it from 3.5% to 3.75%." He added about how long to maintain the terminal rate, "It would be better to discuss rate cuts only after there is clear evidence that inflation is sufficiently converging to the target level (around 2%). Discussions on rate cuts now are premature."