[BOK Focus] Analyzing the Bank of Korea Governor's New Year's Address... First Quarter Interest Rate Hike Likely

BOK Signals Tight Monetary Policy Again This Year
Final Interest Rate May Rise from 3.5% to 3.75%
US 'Pivot' Key...Focus on Timing of Rate Cut

In the new year, a full-scale 'economic cold wave' is expected to hit, but the Bank of Korea is forecasted to maintain its high interest rate stance throughout this year as well. It is highly likely that the first Monetary Policy Committee (MPC) meeting of the year next week or the MPC meeting next month will again raise the interest rate by 0.25 percentage points. The market expects the Bank of Korea to raise the base rate to between 3.5% and 3.75% and maintain it throughout the year. Accordingly, there is also an analysis that the difference in views between the Bank of Korea and the government regarding monetary policy could widen from the second half of the year.

Bank of Korea Governor Lee Chang-yong is explaining the '2022 Second Half Inflation Stabilization Target Operation Status' at the Bank of Korea press room in Jung-gu, Seoul, on December 20 last year. Photo by Joint Press Corps

Will the first MPC meeting of the new year raise interest rates?

Bank of Korea Governor Lee Chang-yong revealed the direction of this year's monetary policy in his New Year's address on the 1st. The core remains a tight monetary policy focused on price stability. Governor Lee explained, "Prices, which are most important to people's lives, are expected to continue rising above the target level," adding, "Monetary policy must continue to focus on price stability." This stance is consistent with the tone he set at the press conference following the November MPC meeting last year and the December briefing on the 'Price Stability Target Operation Status.'

The market expects the Bank of Korea to raise interest rates at least once in the first half of the year. The Bank of Korea will hold MPC meetings on January 13 and February 23 to decide the base rate. Currently, South Korea's base rate is 3.25%, and Governor Lee mentioned 3.50% as the final rate level, so at least one additional rate hike is expected. Since inflation is expected to follow a 'high first half, low second half' pattern this year, the likelihood of a rate hike in January or February is high. The Bank of Korea forecasts inflation rates of 4.2% in the first half and 3.1% in the second half, so pressure for further rate hikes is expected to weaken over time.

Possibility of raising the final rate... depends on U.S. interest rates

The issue is the possibility of raising the final interest rate. Governor Lee said that most MPC members think the final rate will be around 3.5% per annum, but the market expects it could rise to 3.75% depending on domestic and international inflation and financial market conditions. Bank of America and Goldman Sachs also forecast that the Bank of Korea will raise the base rate up to 3.75%. Factors pushing rates higher include inflation expected to be around 5% in the first half, electricity price hikes, and fluctuating international oil prices. According to the Bank of Korea, among the six MPC members excluding Governor Lee, two believe 3.75% is appropriate.

Continued rate hikes in the United States are also a concern. The Federal Reserve (Fed) is expected to raise rates from the current 4.25?4.5% to 5.0?5.25% in the first half of the year. According to the Fed's dot plot released in December last year, the rate for this year is also projected to be 5.00?5.25% (median 5.1%). According to the Chicago Mercantile Exchange (CME) FedWatch on that day, the Fed is expected to raise rates by 0.25 percentage points in both February and March, hold steady in May, and then raise rates again by 0.25 percentage points in June, pushing the final rate above 5%.

High interest rates continue this year... conflict between Bank of Korea and government

Considering the high inflation rate in the first half and the interest rate gap between Korea and the U.S., the Bank of Korea is likely to maintain the base rate above 3.5% for a considerable period. In his New Year's address, Governor Lee pointed out that assuming the continuation of a high interest rate environment, it should be used as an opportunity to reduce the high household debt level and improve the chronic financial vulnerabilities related to Korean real estate. Although the average interest rate on bank household loans has risen to the highest level in 10 years and 8 months due to continued rate hikes, causing significant hardship, this is interpreted as meaning that monetary policy easing is difficult at the moment.

Accordingly, there is also an analysis that conflicts between the Bank of Korea and the government could intensify from the second half of the year. Governor Lee holds the position that tight policy must be maintained until inflation is fully stabilized, but the government may find this monetary policy stance burdensome as it expects a greater economic slowdown this year. This is also reflected in Governor Lee's New Year's address. He said, "As the effects of rate hikes become more pronounced, the possibility of conflicts among price stability, economic growth, and financial stability will increase," adding, "This year will be more important than ever for a more sophisticated policy mix."

On November 2nd last year (local time), Jerome Powell, Chairman of the U.S. Federal Reserve (Fed), held a press conference in Washington DC, USA. [Image source=Yonhap News]

When will interest rates be cut... possible in the second half?

The market is paying attention to the timing of the Bank of Korea's monetary policy shift. As of November last year, the MPC reached a consensus that "it is premature to discuss rate cuts," but depending on factors such as the Fed's rate decisions, China's with-COVID policy, the COVID-19 situation, international oil prices, exchange rates, and the domestic real estate market, the direction could change. The market is divided between forecasts that the rate will be maintained at around 3.5% at least through this year and that rate cuts could begin as early as the second half of the year.

This will also be greatly influenced by the Fed's pivot timing. Fed Chair Jerome Powell said at a press conference after the Federal Open Market Committee (FOMC) regular meeting on December 14 last year (local time), "We have not yet reached a sufficiently restrictive policy stance," dampening market expectations for a pivot. Some argue that Powell, who previously caused confusion by misjudging this inflation as 'transitory,' will not hastily change the policy stance. A Bank of Korea foreign exchange operator predicted, "(The Fed) is expected to maintain a restrictive monetary policy stance and keep policy rates steady until the inflation target is achieved."