Final Interest Rate Clash: 3.5% vs 3.75%... Lee Chang-yong Says "Too Early to Discuss Rate Cuts" (Comprehensive Report 2)

Bank of Korea, First Ever 7 Consecutive Rate Hikes
Between Inflation War and Recession Defense
3 Monetary Policy Committee Members Favor Final Rate at 3.5%
Other 3 Members Open to 3.75% Possibility
Timing of Rate Cut Also in Focus

Lee Chang-yong, Governor of the Bank of Korea, is presiding over the first Monetary Policy Committee meeting of 2023 held at the Bank of Korea in Jung-gu, Seoul on the 13th. Photo by Joint Press Corps

[Asia Economy Reporters Seo So-jeong and Moon Je-won] On the 13th, the Bank of Korea raised the base interest rate by 0.25 percentage points at the Monetary Policy Committee meeting, shifting market attention quickly to the final interest rate and the timing of rate cuts. As the rate hike trend enters its final stage, the key issue is whether the Bank will stop raising rates at 3.5% this month or make one more hike to conclude the cycle at 3.75%.

Lee Chang-yong, Governor of the Bank of Korea, stated that among the Monetary Policy Committee members, three favored keeping the rate steady at 3.5%, while the other three were open to raising it to 3.75%. He emphasized that "a sophisticated monetary policy considering inflation, the economy, and financial stability simultaneously is needed at this time."

At the meeting, the Bank of Korea’s Monetary Policy Committee decided to raise the base rate from 3.25% to 3.50%. Last year, the base rate was raised by 0.25 percentage points in January, April, and May; by 0.50 percentage points in July; 0.25 percentage points in August; 0.50 percentage points in October; and 0.25 percentage points in November. With this month’s additional hike, the rate returns to 3.5% for the first time in 14 years and one month since December 2008. Regarding this decision, committee members Joo Sang-young and Shin Sung-hwan expressed minority opinions favoring maintaining the current 3.25% level.

The Bank of Korea’s decision to raise rates for the seventh consecutive time at this year’s first Monetary Policy Committee meeting is due to persistent inflation expectations. Governor Lee explained the hike by saying, "Consumer price inflation is expected to be around 5% in January and February. Although domestic economic growth is likely to be lower than the November forecast (1.7%), inflation is expected to continue rising above the target level (2%), so it is necessary to maintain a tightening stance focusing on price stability." However, he added, "We will carefully assess downside risks to growth, financial stability risks, the effects of previous rate hikes, the pace of inflation slowdown, and changes in major countries’ monetary policies to determine the need for further hikes."

Lee Chang-yong: "Additional hikes will consider downside growth risks and financial stability"

Market attention is now on the final interest rate and the timing of rate cuts. Although high inflation in the 5% range remains a burden, the recent stabilization of the won-dollar exchange rate and international oil prices, along with a slight decline in expected inflation over the next year, have raised the possibility of shifting monetary policy focus toward economic slowdown and the real estate market.

Experts are divided between 3.5% and 3.75% as the final interest rate. The Bank of Korea raised rates this month amid ongoing high inflation, but from next month, it will need to review the effects of previous hikes while monitoring price stability and the extent of domestic economic slowdown. Yoon Yeo-sam, a researcher at Meritz Securities, predicted, "After the January hike, additional increases will not be made unless there is an unexpected upward shock to inflation." An Jae-kyun, economist at Shinhan Investment Corp., said, "Considering the ongoing trend of public utility fee hikes, the contribution of administered prices to this year’s Consumer Price Index (CPI) inflation is expected to remain high. This means future inflation will be largely cost-driven, which reduces consumer spending power and weakens growth, making 3.5% likely to be the final rate."

On the other hand, there are considerable opinions that an additional hike is necessary next month, considering the interest rate gap between Korea and the U.S. The gap, which widened to 1.25 percentage points after the Fed’s 0.50 percentage point "big step" hike in December, narrowed slightly to 1 percentage point with this month’s hike. However, as the Fed’s tightening is expected to continue, pressure is mounting on the Bank of Korea to raise rates. Woo Hye-young, a researcher at eBest Investment & Securities, said, "The Fed’s strong commitment to achieving price stability is likely to continue through the first quarter. If the Fed realizes the final rate level of 5.25% indicated in the December dot plot, the Bank of Korea will need to raise rates to 3.75%."

Regarding this, Governor Lee said at a press conference following the Monetary Policy Committee meeting, "Three committee members thought it was appropriate to keep the final rate at 3.5% and observe its effects for a while. The other three were open to the possibility of the final rate reaching 3.75% depending on circumstances." When asked about his personal view amid the 3-to-3 split, he replied, "I did not express an opinion today because it is not appropriate to take sides amid uncertainty. I will share my view when it is absolutely necessary."

Lee Chang-yong, Governor of the Bank of Korea, is explaining the base interest rate hike at a press conference held on the 13th at the Bank of Korea in Jung-gu, Seoul. The Monetary Policy Committee of the Bank of Korea raised the base interest rate by 0.25 percentage points from 3.25% to 3.50% on the same day. Photo by Joint Press Corps

Rate cuts: Q4 this year vs. next year... Election variables

Experts are divided on the timing of rate cuts, with some expecting them as early as Q4 this year and others seeing them pushed to next year. Huh Jin-wook, professor of economics at Incheon National University, said, "Inflation is slowing gradually, and the economy, especially manufacturing, is weak, so discussions on rate cuts could begin as early as the second half of the year. The U.S. inflation rate and the timing of its monetary policy shift are important variables."

Huh Joon-young, professor of economics at Sogang University, said, "Although the Fed has said it will not start cutting rates this year, Korea’s economy is clearly weakening, and household loans and funding market issues persist, so it is possible Korea could start rate cuts earlier than the U.S." Joo Won, head of economic research at Hyundai Research Institute, said, "As the real economy recession intensifies in the second half of this year in both the U.S. and Korea, discussions on rate cuts will begin. With the U.S. presidential election and Korea’s general election next year, pressure for rate cuts could increase."

On the other hand, Huh Jung-in, researcher at Daol Investment & Securities, said, "Due to continued tightening in the U.S., Europe, and Japan, the Bank of Korea is unlikely to make a premature pivot. If a pivot causes inflation to resurge or domestic financial imbalances to worsen, the environment may require raising the base rate, making rate cuts this year difficult." Jo Young-moo, research fellow at LG Economic Research Institute, also said, "It would be burdensome for Korea to cut rates before the U.S. If inflation remains high, the Bank of Korea may not start rate cuts this year."

Regarding the possibility and timing of rate cuts, Governor Lee said, "It is premature to talk about rate cuts before we are confident that inflation is clearly converging to our expected level. Since there are both upside and downside risks to inflation, it is appropriate to discuss rate cuts only when we are confident that inflation will reach our target level in the medium to long term."

When asked if Korea could start rate cuts before the U.S., Governor Lee said, "Interest rate decisions prioritize domestic conditions. However, if the pace of U.S. rate hikes continues and the interest rate gap widens significantly, we will consider concerns about financial stability and make decisions accordingly. Fundamentally, we have created conditions to make rate decisions based on domestic circumstances."

Additionally, Governor Lee forecast that this year’s domestic economic growth rate will be lower than the Bank of Korea’s November forecast of 1.7%. He said, "Looking at various economic indicators released over the past month, the possibility of growth being lower has increased. However, this is a common phenomenon worldwide, and compared to the recession risks in major countries, our situation is better."