[2023 Economic Outlook] Will the Bank of Korea Shift Focus from 'Inflation to Growth'... What About the Final Interest Rate?

Considering Slowdown in Real Estate and Short-Term Funding Markets

[Asia Economy Reporter Seo So-jung] As high inflation in the 5% range is expected to continue until the first quarter of next year, attention is focused on how long the Bank of Korea's (BOK) base rate hike will continue. The base rate, which was only 0.5% last August, surged by 2.75 percentage points to 3.25% in just one year and three months due to the U.S. Federal Reserve's (Fed) unprecedented high-intensity tightening. However, with the recent spread of the inflation peak theory and the forecast of a full-scale global economic recession next year, it is expected that the focus of monetary policy will gradually shift from inflation to growth. The skyrocketing interest burden due to household debt reaching 1,870 trillion won and the worsening real estate market also support the BOK's call for a slowdown in the pace of rate hikes.

◆High inflation in the 5% range to continue for the time being= According to major domestic and international economic institutions on the 6th, South Korea's consumer price inflation rate is expected to be in the 3% range next year. In its revised economic outlook last month, the BOK lowered its forecast for next year's consumer price inflation rate from 3.7% to 3.6%, down 0.1 percentage points from August. Although South Korea's consumer price inflation rate will fall from the 5% range this year to the 3% range next year, the 3% inflation rate is the highest level since 2008 (4.7%) excluding this year and exceeds the BOK's inflation target of 2.0%. Hong Kyung-sik, Director of the Monetary Policy Department at the BOK, said, "Although inflation is expected to gradually decrease after the second quarter of next year, there is significant uncertainty regarding the degree of cost pass-through of accumulated cost pressures, exchange rate and international oil price movements, and the extent of economic slowdown," adding, "Until the outlook for inflation converging to the target level becomes clear, it is necessary to continue a monetary policy stance focused on inflation."

The market expects the BOK to maintain a tightening stance for the time being to respond to high inflation. However, with U.S. Fed Chair Jerome Powell recently mentioning the possibility of slowing the pace of tightening, market expectations have grown that the Fed will slow the pace of rate hikes this month. Considering the contraction of the short-term financial market triggered by the Legoland incident and project financing (PF) asset-backed commercial paper (ABCP), a slowdown in pace is expected.

According to the Korea Financial Investment Association, the CP (91-day) rate remained at 5.54% per annum yesterday, the same level as on the 2nd. The corporate commercial paper (CP) rate, which had been soaring due to ongoing corporate funding difficulties in the short-term money market, is gradually calming down as additional measures such as the government's liquidity supply plan exceeding 50 trillion won continue. As the general bond market tightened, demand for short-term funds like CP surged, causing the CP rate to rise for 49 consecutive trading days from September 22 to October 1. A BOK official said, "It seems that the government's and BOK's liquidity supply measures have had some effect, but the level of illiquidity remains high compared to the beginning of the year," adding, "The short-term financial market is the primary channel through which monetary policy is transmitted, so we are closely monitoring the related market."

The impact of the global economic recession next year, which is expected to keep South Korea's economic growth rate in the 1% range below the potential growth rate (2%), also supports the call for a slowdown in the pace of rate hikes. Kim Young-ik, professor at Sogang University Graduate School of Economics, said, "The Korean economy is expected to show negative growth in the first half of next year," adding, "With the U.S. inflation rate slowing, interest rates falling, and the dollar weakening, the monetary policy direction will shift from inflation to recession." According to BOK analysis, a 25 basis point (bp) increase in the domestic base rate is estimated to reduce the first-year growth rate by 0.06 to 0.07 percentage points, and a 50 bp increase by about 0.1 percentage points.

◆Final rate around 3.5%... Opinions differ on timing of rate cuts= Experts predict that the BOK will continue to raise the base rate until the first quarter of next year, with the final rate expected to be around 3.5%. At last month's Monetary Policy Committee (MPC) meeting, BOK Governor Lee Chang-yong said, "Opinions among MPC members were divided" regarding the final rate, adding, "Three members thought 3.5% was desirable, one member preferred 3.25%, and two members thought it was desirable to keep open the possibility of raising it from 3.5% to 3.75%." Governor Lee, who disclosed the opinions of six MPC members excluding his own at last month's meeting, recently said in an interview with foreign media, "I hope to conclude the base rate hikes around 3.5%." Accordingly, the view that the BOK will raise the base rate once more (by 0.25 percentage points) in the first quarter of next year and then conclude the rate hike cycle is gaining traction.

Following Governor Lee's dovish remarks (favoring monetary easing), some investment banks (IBs) that had predicted a final rate of up to 3.75% are lowering their final rate forecasts. Park Seok-gil, head of JP Morgan's Financial Market Operations Department, revised his previous forecast after last month's MPC meeting, saying, "The BOK will raise the rate by 0.25 percentage points at the January MPC meeting next year and conclude rate hikes at 3.5%." Kim Jung-sik, emeritus professor of economics at Yonsei University, said, "With the won-dollar exchange rate stabilizing and concerns about a hard landing of the domestic economy or a real estate bubble collapse emerging, the BOK is likely to stop rate hikes at around 3.25% to 3.5%."

However, opinions differ on the timing of rate cuts. Park said, "A pivot (direction change) by the end of next year is premature," adding, "The BOK will maintain a neutral or tighter policy stance until the inflation trend stabilizes sufficiently." The BOK has projected South Korea's economic growth rate at 2.3% and inflation at 2.5% for 2024. Since inflation is expected to fall to the BOK's target level of 2% and growth to recover to the potential growth rate of around 2%, rate cuts are expected to occur after 2024. On the other hand, Kang Min-joo, senior economist at ING Bank Seoul Branch, predicted, "If the U.S. cuts rates again from the second half of next year, South Korea is also likely to enter a rate-cut cycle," adding, "South Korea will start cutting rates in the third quarter of next year."