[The Editors' Verdict] Is the Bank of Korea Independent from the US Fed?

Lee Chang-yong, Governor of the Bank of Korea, said at the end of August last year, "The Bank of Korea is independent from the government but not independent from the U.S. central bank, the Federal Reserve (Fed)." This meant that if the U.S. continues to raise its benchmark interest rate, the Bank of Korea would have no choice but to follow suit.

However, the atmosphere has recently changed. Although the U.S. Fed raised its benchmark interest rate by 0.25 percentage points to 4.50-4.75% on the 1st of last month (local time), the Bank of Korea kept its benchmark rate unchanged at 3.5% on the 23rd of the same month, about 20 days later. The Fed is expected to raise the benchmark interest rate at the Federal Open Market Committee (FOMC) meeting scheduled for the 21st-22nd. The issue is whether the increase will be 0.25 or 0.50 percentage points, but the hike is a foregone conclusion.

Unlike last August, has the Bank of Korea suddenly become independent from the Fed? At a press conference after the Monetary Policy Committee meeting in February this year, when the Bank of Korea kept the rate unchanged, Governor Lee explained in response to a question asking if this contradicted the previous stance, "In the second half of last year, we wanted to conduct monetary policy based on Korea's inflation path, but the variable of the exchange rate came into play," adding, "The Bank of Korea was forced into a situation where it had to follow the Fed." He stated, "Are we independent from the Fed? No... Our decisions always consider the monetary policies of major countries, but unlike last year, now is the time to mainly focus on domestic factors and the inflation pass-through when conducting monetary policy."

At the time, this was puzzling. Within just six months, the Bank of Korea no longer needs to follow the Fed? While saying it is not independent from the Fed... it seems the Bank of Korea is acting as if it is independent?

On the 6th, Asia Economy published an interview with Yang Seok-jun, Director of Foreign Exchange Operations at the Bank of Korea. When asked, "Won't there be capital outflows as the interest rate gap between Korea and the U.S. widens?" Director Yang replied, "For capital to flow out due to the widening interest rate gap, a strong expectation of won depreciation (exchange rate increase) must form as an intermediate step," adding, "For the interest rate gap to significantly affect the exchange rate in the future, there must be a supporting forecast that the U.S. will rapidly raise rates as it did last year."

Only then did it become clear. In October-November last year, the rapid U.S. rate hikes combined with bond market instability caused by the Legoland incident pushed the won-dollar exchange rate up to around 1,450 won per dollar. In situations like then, where financial market instability raises the possibility of won depreciation, the Bank of Korea has no choice but to follow the Fed. If market participants expect a further sharp depreciation of the won, capital outflows become a concern, so the Bank of Korea needs to curb expectations of won depreciation.

However, from December last year to recently, the exchange rate has been relatively stable. After the Bank of Korea kept the benchmark rate unchanged, the won-dollar exchange rate, which was around 1,230-1,240 won, rose to about 1,320 won but soon fell back below the 1,300 won level. In such a situation, the Bank of Korea can conduct monetary policy based on domestic economic conditions such as inflation.

The current U.S. benchmark interest rate is 4.75%, and it is expected to reach 5% or 5.25% by the end of this month. The highest forecast for the U.S. terminal rate is around 6%. If there is no significant additional hike beyond the 5% level, it seems unlikely that the won-dollar exchange rate will rise that much. Moreover, the Bank of Korea has stated that it will maintain a tightening stance and has left open the possibility of further rate hikes. If the exchange rate surges sharply, the Bank of Korea’s judgment appears to be that it can respond with a rate hike at that time.

Governor Lee said at a discussion hosted by the Broadcast Journalists Club on the 7th, "As expected, inflation in February fell to 4.8%, and from March onward, we expect it to be below 4.5%, with the year-end forecast in the low 3% range." The Bank of Korea is scheduled to hold a Monetary Policy Committee meeting on April 11 to decide the benchmark interest rate. The March inflation data will be released on April 4, one week earlier. Not only the Bank of Korea but also the government expects March consumer prices to decline further.

The author forecasts that "if the exchange rate does not surge sharply, the benchmark interest rate will also be kept unchanged at the April Monetary Policy Committee meeting."