[Insight & Opinion] The Bank of Korea's Endless Interest Rate Dilemma

Used car prices and gasoline prices have risen again. The inflation rate in the United States in January far exceeded expectations. I thought the possibility of inflation reigniting was low, but the unlikely concern became a reality. The U.S. Federal Reserve (Fed) has raised interest rates by 4.5 percentage points over the past 11 months, but the expectation that inflation would rapidly decrease was off the mark. The hope that rate hikes would soon end has begun to crack.

At a time when concerns about a U.S. economic recession have weakened, the focus is shifting back to inflation. It seems it will take more time for inflation to fall to the target level of 2%. Hawkish Fed officials who favor monetary tightening argue that the February rate hike should have been 0.5 percentage points instead of 0.25 percentage points. The argument for a big step (a 0.50 percentage point increase in the benchmark rate) in March has also increased due to the strong labor market. So far, the Fed’s tightening policy has had little impact on the labor market. After all, in 2006, it took a year and a half for rate hikes to affect the employment market. The better-than-expected U.S. economic situation could negatively affect our economy through the Fed’s interest rate hike path. If the U.S. rate hike period is extended or the magnitude of hikes increases, policymakers’ concerns will inevitably deepen.

First, uncertainty about future rate hikes by the Bank of Korea is increasing. If the U.S. rate hike ends with a baby step (a 0.25 percentage point increase) in March, the interest rate differential with the U.S. is expected to be about 1.5 percentage points. A difference of more than 1.5 percentage points is uncharted territory. It now seems that the Bank of Korea’s choices cannot be independent of U.S. rate hikes. The longest period when the benchmark interest rate was inverted between Korea and the U.S. was from August 2005 to August 2007. During this period, the maximum interest rate gap was 1.5 percentage points. If the interest rate gap widens further, exchange rate instability and difficulties in price management are expected. The impact on the trade balance could also be negative if high oil prices persist.

What would happen if the Bank of Korea raises rates further? In our reality, where the proportion of variable-rate loans is high, the shock of rate hikes could be transmitted to companies and households. Last year, delinquency rates at commercial banks rose across the board, triggering warning signs in soundness management, and delinquency rates continue to increase. If rates rise further, concerns about the risk of loan defaults will inevitably grow. Tailored support for vulnerable borrowers, such as low-income groups at high risk of debt default and young people who have leveraged real estate loans, will become urgently necessary.

Although housing prices remain high relative to income, voices warning about a sharp drop in real estate prices should also be heeded. A sharp decline in housing prices would have a tremendous impact on households and construction companies. This leads to consumption slowdown and reduced investment. The shadow of uncertainty could deepen further over real estate project financing (PF), which is already struggling due to drying up of funds.

Larry Summers, former U.S. Treasury Secretary, viewed the Fed’s potential big step in March negatively but raised the possibility of future benchmark rate hikes exceeding 0.25 percentage points. He emphasized that the Fed should avoid binding itself with strong tightening or easing signals. In any case, it has become even more difficult to gauge the Fed’s inflation response policy path. The most likely scenario at present is consecutive 0.25 percentage point rate hikes in March and May. With increased uncertainty in our economy and policy response, attention will inevitably rise on whether the Bank of Korea can properly unravel the tangled threads. In this situation, both ruling and opposition parties should not just engage in political strife but should put their heads together and properly address the livelihood issues.

Wonkyung Cho, Professor at UNIST / Director of the Global Industry Cooperation Center