[BOK Focus] Lee Chang-yong Contemplating Potential Growth Rate... Will It Signal Monetary Policy?

"Aftermath of 'Neutral Interest Rate Increase, Korea Exception' Remarks"

"Higher for longer interest rates are a major global agenda, but Korea is not a typical case." (Lee Chang-yong, Governor of the Bank of Korea, interview with CNBC USA)

Following Governor Lee Chang-yong's recent interview remarks, various interpretations have emerged in the market, causing aftershocks. On the 11th (local time), while attending the G20 Finance Ministers and Central Bank Governors Meeting in Marrakech, Morocco, Governor Lee stated in an interview with a foreign media outlet that in response to a question about the possibility of raising the neutral interest rate amid rising inflation due to geopolitical divisions, "Korea must consider the special factor of its demographic structure."

Governor Lee said, "Korea has a very low birth rate and an aging population structure that is rapidly aging, so we need to examine how much global factors will dominate versus our internal factors such as low growth potential due to aging," adding, "Korea is not a typical case (in discussions about raising the neutral interest rate)."

Amid heated debates on raising the neutral interest rate following the U.S. Federal Reserve's indication of prolonged high interest rates, Governor Lee emphasized that Korea could be an exception based on its low growth potential, leading some to interpret this as a kind of signal regarding future monetary policy.

At the Monetary Policy Committee meeting scheduled for the 19th, considering the recent rebound in inflation, economic recession, and uncertainties in U.S. monetary policy, the Bank of Korea is expected to maintain the base rate for the sixth consecutive time. However, there is also an assessment that this indirectly reveals that a full-fledged exit strategy could begin next year when a monetary policy shift is anticipated.

In particular, the recent move by the Bank of Korea to estimate the potential growth rate after COVID-19, with plans to announce it by the end of the year, adds weight to this interpretation. The Bank of Korea regularly announces potential growth rates, and the most recent estimate released in September 2021 was around 2% for 2021?2022. During the COVID-19 period of 2019?2020, it was 2.2%, but since then, the potential growth rate has been on a downward trend, and the upcoming estimate to be announced at year-end is expected to fall to the 1% range.

Decline in Potential Growth Rate → Lower Neutral Interest Rate → Possible Monetary Easing

The reason for the focus on the potential growth rate is its significant impact on the neutral interest rate. Low birth rates and aging are major factors eroding Korea's potential growth rate. Due to changes in the demographic structure leading to a decrease in the working-age population, the potential growth rate is expected to be revised downward to the 1% range, which could lower the neutral interest rate.

The neutral interest rate is the rate at which the economy neither overheats nor falls into recession, representing an ideal rate where economic growth and stable inflation are balanced. If the base rate is raised excessively above the neutral rate, the economy may slow sharply; if the base rate is below the neutral rate, inflation cannot be controlled. Therefore, aligning the base rate close to the neutral rate is a key task for central banks. Especially for Korea, which is currently experiencing export sluggishness, this could lead to economic downturn and a decline in potential growth rate, exerting downward pressure on the neutral interest rate.

Governor Lee's mention of Korea's severe low birth rate and aging leading to a decline in potential growth rate in response to questions about the possibility of raising the neutral interest rate, and his statement that "Korea's situation is not typical," is interpreted as a signal that the neutral interest rate could decline in the long term, which could serve as a basis for future monetary easing. In other words, although the global trend of prolonged high U.S. interest rates is ongoing, Korea, with the possibility of a declining neutral interest rate due to falling potential growth, could deviate from this trend first.

Hyo-sung Kwon, an economist at Bloomberg Korea, said, "Due to the Israel-Palestine war, international oil price uncertainty is high, and from the Bank of Korea's perspective, which prioritizes inflation in monetary policy decisions, immediate monetary easing is unlikely. However, while the U.S. is engaged in heated debates about raising the neutral interest rate, Korea's economy, facing recession and declining potential growth, may see a possibility of lowering the neutral interest rate, which could serve as one reason why Korea's rate cut timing next year might be one to two months earlier than the U.S."

Regarding this, a Bank of Korea official said, "We are currently estimating the potential growth rate with the goal of year-end, but it is difficult to finalize the announcement timing as it depends on how the impact of the COVID-19 pandemic shock is reflected. Given the increased volatility in oil prices due to the Israel-Palestine war and ongoing uncertainties in U.S. monetary policy, the Bank of Korea, which must maintain tightening, considers it premature to link the governor's remarks on potential growth rate to monetary easing."