[Why&Next] Korea and the US Face Deepening Interest Rate Concerns... Is an Interest Rate Cut Imminent?

The Bank of Korea "Focuses on Financial Market Stability"
Base Rate Held Steady at 3.5% for 4 Consecutive Times
Historic Maximum Interest Rate Gap with US Amid Controlled Inflation

[Image source=Yonhap News]

Amid economic and financial instability, the Bank of Korea (BOK) kept its benchmark interest rate steady at 3.5% per annum during the Monetary Policy Committee meeting on the 13th. This marks the fourth consecutive hold following freezes in February, April, and May. The decision was influenced by June's consumer price inflation dropping to the 2% range, a slower-than-expected economic recovery in the second half of the year, and ongoing financial concerns such as the sharp rise in delinquency rates at Saemaeul Geumgo and instability in real estate project financing (PF), which reduced the need for further rate hikes.

Another factor supporting the end of rate hikes in Korea is that the U.S. Federal Reserve's (Fed) tightening cycle, one of the biggest variables in monetary policy for the second half, is nearing its conclusion. Experts predict that the BOK's rate hike cycle has effectively ended and that the time to coordinate a rate cut to stimulate the economy is approaching.

At the monetary policy direction meeting held that day, the BOK's Monetary Policy Committee decided to keep the benchmark interest rate at 3.50% per annum. Since August 2021, the committee had paused rate hikes for a year and a half starting in February, entering a 'breather' phase, and this month marked the fourth consecutive freeze following April and May.

The main rationale for the freeze is economic and financial instability. The Ministry of Economy and Finance lowered its real gross domestic product (GDP) growth forecast for this year from 1.6% to 1.4% in its 'Second Half Economic Policy Direction' released earlier this month. The BOK also revised down its growth forecast to 1.4% at the end of May, lowering it by 0.2 percentage points due to continued export sluggishness and a slowdown in consumer recovery. The global economic slowdown and delayed recovery of the Chinese economy have led to continued downward revisions in growth expectations. Concerns remain over potential financial market tightening due to the Saemaeul Geumgo crisis and unresolved instability in real estate PF and the secondary financial sector.

The BOK's expectation that inflationary pressures are gradually easing also underpinned the rate freeze. The consumer price inflation rate in June was 2.7%, returning to the 2% range for the first time in 21 months since September 2021, alleviating inflationary burdens. Lee Chang-yong, Governor of the BOK, emphasized, "While the domestic economy is gradually improving, inflation is expected to exceed the target level for a considerable period, and policy uncertainties remain high, so we will maintain a tightening stance focused on price stability for a significant period."

At the end of this month, the Korea-U.S. interest rate gap will reach a record high of 2.0 percentage points

[Image source=Yonhap News]

With the BOK freezing its benchmark rate, the gap with the U.S. rate (4.75?5.00%) remains at a record high of 1.75 percentage points at the upper bound. If the U.S. Federal Reserve raises its policy rate by 0.25 percentage points as expected on the 26th (local time), the Korea-U.S. interest rate gap will widen to 2.00 percentage points. Such an unprecedented gap raises the possibility of increased volatility in the foreign exchange market due to foreign capital outflows. However, experts note that despite the historically large interest rate differential, the won-dollar exchange rate has attempted to enter the 1,200 won range, showing relatively stable trends, so there is no need to worry excessively about sudden capital outflows or won depreciation.

Kang Sung-jin, Professor of Economics at Korea University, said, "There are concerns about the won-dollar exchange rate rising as the Fed hikes rates and the BOK holds steady, widening the interest rate gap, but since the economy is very weak, the BOK seems to have accepted this risk to maintain the freeze. Ultimately, inflation is the biggest variable in monetary policy, and unless inflation resumes an upward trend, the BOK will likely maintain the freeze for a while and then follow the Fed's lead when it starts cutting rates."

The news of easing inflation in the U.S. also reduced the pressure for additional rate hikes. According to the U.S. Department of Labor on the 12th (local time), the U.S. Consumer Price Index (CPI) rose 3.0% year-on-year in June, below the market expectation of 3.1%, marking the lowest level since March 2021. The core CPI, which excludes volatile energy and food prices closely watched by the Fed, increased 4.8% year-on-year, below the market forecast of 5.0%, representing the smallest rise since October 2021.

Will the Fed's July hike be the last? Expectations for the end of tightening

With inflationary pressures easing, market expectations are growing that the Fed will end its tightening cycle after the July rate hike. Kim Jung-sik, Emeritus Professor of Economics at Yonsei University, said, "The U.S. core inflation has slowed more than expected, making it highly likely that July will be the last rate hike. Given the increased possibility that the Fed will gradually cut rates starting next year, Korea also faces less pressure for further rate hikes."

With the BOK holding rates steady for four consecutive times, some speculate that a rate cut could come as early as the end of this year. Joo Won, Head of Economic Research at Hyundai Research Institute, predicted, "China's economic recovery is far below expectations, leading to continued sluggish exports and domestic demand. To stimulate the economy, the BOK is expected to lower rates starting in the fourth quarter."

Yoo Hye-mi, Professor of Economics and Finance at Hanyang University, noted, "The rapid decline in inflation means the current interest rate level is sufficiently tight. Although the BOK raised rates preemptively in August 2021 due to a surge in household debt, the current economic downturn phase is different from that time."

Heo Jun-young, Professor of Economics at Sogang University, pointed out, "The economy is so weak that there is talk in the market about the need to cut rates within this year, and recent weak links in the financial sector are gradually breaking, so the BOK has no choice but to shift its focus toward rate cuts." Regarding the recent surge in household debt, Professor Heo added, "We need to observe whether the increase in household debt is temporary or a trend. Given concerns about a reverse jeonse (key money deposit) crisis in the second half, it will be difficult to raise rates because of household debt."

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