[Inside Chodong] Careful Monetary Policy Needed in the Era of Prolonged High Interest Rates

Deputy Prime Minister and Minister of Economy and Finance Choo Kyung-ho, Bank of Korea Governor Lee Chang-yong, Financial Services Commission Chairman Kim Ju-hyun, and Financial Supervisory Service Governor Lee Bok-hyun are attending the Emergency Macroeconomic and Financial Meeting held at the Bankers' Hall in Myeong-dong, Jung-gu, Seoul on the 21st, engaging in discussion. Photo by Jo Yong-jun jun21@

Jerome Powell, Chairman of the U.S. Federal Reserve (Fed), hinted at a 'prolonged period of high interest rates' during the Federal Open Market Committee (FOMC) regular meeting held on the 19th-20th (local time), complicating the calculations of major central banks. Powell emphasized that the current tightening stance will last longer by suggesting that even if the benchmark interest rate is raised further within this year and cut next year, the rate cuts will be smaller than expected. Recently surging international oil prices have once again fueled inflation, which had been gradually calming down, and the much stronger-than-expected U.S. economy signals a prolonged tightening cycle.

What stood out most in this FOMC meeting was the Fed's significant upward revision of the U.S. economic growth forecast for this year from 1.0% in June to 2.1%, and the next year's forecast was also raised from 1.1% to 1.5%. The U.S. labor market remains hot, and consumption indicators are also robust, suggesting that the duration of the current tightening stance could be extended.

As the U.S. also raised its terminal interest rate forecasts for next year and 2025 by 0.5 percentage points each compared to the June projections, signaling a 'higher for longer' tightening stance, the Bank of Korea's concerns over monetary policy are expected to deepen. November is an immediate issue. If the Bank of Korea holds the base rate steady next month and the Fed raises its benchmark rate again in November, the interest rate gap between Korea and the U.S. could widen to as much as 2.25 percentage points at the upper bound. The Korea-U.S. interest rate gap has already reached a historic high of 2 percentage points, and an unprecedented 2.25 percentage point gap could become a reality. Although market concerns over the Korea-U.S. interest rate inversion have eased compared to before, the possibility of foreign capital outflows and volatility in the foreign exchange market cannot be ruled out.

The Fed's indication of a prolonged high interest rate environment inevitably burdens the Korean economy. If the tightening period continues and U.S. growth slows down in the future, it will negatively affect Korea's exports, and even if domestic economic recovery is delayed, the historically wide Korea-U.S. interest rate gap will prevent Korea from lowering rates prematurely. On the 24th of last month, Bank of Korea Governor Lee Chang-yong expressed concern at a Monetary Policy Committee press conference, saying, "If the U.S. monetary policy stance continues to tighten, we will face constraints when considering whether we can ease more aggressively." This means that even if Korea wants to cut rates considering domestic economic slowdown, it will inevitably face constraints in monetary policy as long as U.S. rates remain high.

If the U.S. raises rates once more within this year, the Bank of Korea will face a dilemma. It is not easy to follow the rate hike amid ongoing economic uncertainty in the second half of the year and lingering financial risks such as real estate project financing (PF). In a press briefing last month, Governor Lee warned the younger generation buying homes with borrowed money, saying, "Low interest rates may not return again, so be cautious." Powell's remarks about prolonged high interest rates have increased the likelihood that Governor Lee's advice will become reality.

As the equation surrounding monetary policy becomes more complex, the Bank of Korea's dilemma over the timing of future rate cuts grows. In his speech commemorating the 73rd anniversary of the Bank of Korea in June, Governor Lee emphasized, "As inflation and economic conditions diverge across countries, this year will be a true test of the Bank of Korea's capabilities." However, in a situation where inflation and growth conflict, monetary policy alone cannot overcome the crisis. With economic uncertainties increasing and the importance of fiscal and monetary policies growing, it is a crucial time for policymakers to work together to navigate through this period of uncertainty.