[2023 Economic Policy] Government vs HanEun, Different Dreams on Inflation and Base Interest Rate

Government Lowers Growth Rate Below BOK and KDI
Monetary Policy Shrouded in Uncertainty
Growth and Inflation Poised for a Tight Tug-of-War

[Asia Economy Reporter Seo So-jeong] As the global economic downturn next year slows South Korea's 'growth,' the Bank of Korea's monetary policy is engulfed in uncertainty. Consumer prices are pointing to interest rate hikes, recording a 5% range far above the 2% inflation target until early next year. However, with the global economic contraction leading to sluggish exports and investment, and the full impact of high interest rates beginning to take effect, the burden of additional rate hikes is increasing.

In particular, the government has lowered its economic growth forecast for next year to 1.6%, below the Bank of Korea's 1.7%, due to worsening external conditions. Growth is expected to fall below potential levels in the first half of next year, signaling a tense tug-of-war in monetary policy between growth and inflation. Some predict that a full-scale power struggle could emerge next year between the Bank of Korea, which focuses on high inflation, and the government, which aims to restrain base rate hikes considering growth and the economy.

Government Forecasts Consumer Inflation at 3.5% Next Year

On the 21st, the Ministry of Economy and Finance raised its consumer price inflation forecast for next year to 3.5%, 0.5 percentage points higher than the previous estimate of 3.0%, in the '2023 Economic Policy Direction' announcement. This is 0.1 percentage points lower than the Bank of Korea's 3.6% forecast in last month's revised economic outlook. The forecast expects a slowdown in consumer price inflation compared to this year's 5.1%, due to falling global commodity prices such as international oil prices and weakened demand amid the global economic downturn.

On the 19th, Deputy Prime Minister and Minister of Economy and Finance Choo Kyung-ho said at a press briefing with economic reporters, "High inflation in the 5% range will continue until early next year, but monthly consumer price increases are expected to gradually slow down in the second half of next year," adding, "It is expected to come down to the 4% and 3% ranges, and eventually reach the 2% range." As consumer price inflation approaches the inflation target, there is optimistic expectation that the Bank of Korea may pivot to freezing or lowering interest rates.

On the other hand, the Bank of Korea maintains a monetary policy stance focused on inflation, as the high inflation in the 5% range is expected to continue for the time being. Bank of Korea Governor Lee Chang-yong said at a press conference reviewing inflation target operations the day before, "Although inflation will show a high-to-low trend next year and gradually decline, it will remain at a high level above the 2% inflation target," adding, "It is necessary to continue monetary policy operations focused on inflation."

He also dismissed discussions of rate cuts as premature. Governor Lee emphasized, "We can discuss rate cuts only when there is confidence that inflation will converge to our target in the medium to long term, but it is still premature," and stressed, "Price stability is an unchangeable duty of the Bank of Korea." Although inflation is expected to slow down toward the second half of next year, risks remain, such as upward pressure on public utility fees like electricity rates and potential fluctuations in commodity prices due to geopolitical uncertainties involving Ukraine and Russia, making premature expectations for base rate cuts difficult.

In last month's revised economic outlook, the Bank of Korea projected consumer price inflation next year at 4.2% in the first half and 3.1% in the second half. When asked whether the inflation forecast would be revised upward due to a large increase in electricity rates next year, Governor Lee replied, "When we made the forecast last month, we expected electricity rates to rise as much as they did this year, but now we think they might rise even more," adding, "However, international oil prices have fallen significantly compared to previous forecasts, so the decline in oil prices and the increase in electricity rates are expected to offset each other."

Governor Lee's view on the record-high household debt of 1,870 trillion won also supports the rate hike stance. He recently stated regarding whether policy rate hikes would lead to deleveraging, "Household debt is a significant medium to long-term risk factor, so deleveraging is necessary."

Bank of Korea Governor Lee Chang-yong is explaining the "2022 Second Half Inflation Target Management Status" at the Bank of Korea press room in Jung-gu, Seoul, on the 20th. Photo by Joint Press Corps

Diverging Views on Timing of Rate Cuts

The market expects the Bank of Korea to maintain its rate hike stance until early next year when consumer inflation remains in the 5% range, but if growth falls too sharply in the first half of next year, the situation could change. Governor Lee also diagnosed, "The economy is expected to be very difficult in the first half of next year, so it is on the borderline whether it will go into a recession or not." He expressed concerns about monetary tightening possibly being an under- or overreaction, calling it "the biggest worry," and said, "If we respond too late, the recession could worsen, but if we respond too early and inflation rises again, there is a risk of losing trust in monetary policy."

With expectations that the U.S. Federal Reserve (Fed) will cut rates starting in 2024, there is also a burden in starting rate cuts before the Fed. However, Governor Lee left room for flexibility, saying, "If inflation falls significantly from 5% and there is confidence that it will converge to the medium- to long-term inflation target, it is a very natural central bank monetary policy approach to consider sound economic development and financial stability even before inflation reaches 2%."

Joo Won, Senior Researcher at Hyundai Research Institute, said, "The government generally forecasts economic growth higher than the Bank of Korea or the Korea Development Institute (KDI), but lowering it clearly signals that the economy is difficult, and it seems to be an implicit message that the Bank of Korea should cut rates in the second half of next year." He added, "Currently, both the government and the Bank of Korea prioritize price stability due to high inflation, but if inflation slows and falls to the 3% range, discussions on rate cuts will surface. The government and political circles, with elections ahead in 2024, may pressure for base rate cuts out of concern for the economy."