[Q&A] "Price Decline Likely to Slow... Difficult to Predict Impact of Israel-Palestine War"

Press Conference on Monetary Policy Direction by the Financial Monetary Committee on the 19th
"Current Monetary Policy at a Tightening Level"
"One Monetary Policy Committee Member Suggested Flexibility Despite Possibility of Lowering Interest Rates"

Lee Chang-yong, Governor of the Bank of Korea, stated on the 19th, "The pace of the decline in inflation is expected to be slower than the path predicted last August."

Governor Lee made this remark during a press conference held after the Monetary Policy Committee meeting on the direction of monetary policy that morning, saying, "It is difficult to predict what will happen due to the Israel-Hamas conflict."

Last August, the Bank of Korea projected consumer price inflation rates of 3.5% for this year and 2.4% for next year. Governor Lee explained, "The coming weeks will be very important," adding, "Regardless of what happens, given the current situation, the consensus among the Monetary Policy Committee members is that the pace of inflation decline will likely be slower than the path predicted in August."

[Image source=Yonhap News]

The following is a Q&A session with Governor Lee Chang-yong.

- Recently, inflation has rebounded sharply, and household and corporate debt are rapidly increasing. Is it reasonable to consider the current base interest rate as being at a tightening level?

▲ We consider it to be tightening. There are various ways to assess the degree of monetary policy tightening, such as comparing interest rates to the neutral rate or using price variables. Judging solely by household and corporate loans without considering price variables may not be appropriate. Concerns about household and corporate loans stem from risk management and worries about the economic impact. However, an increase in corporate loans does not necessarily mean that the interest rate level is not tight. Recently, the rise in corporate loans partly reflects a shift from issuing corporate bonds to borrowing due to increased corporate bond yields. For example, some large corporations are currently borrowing to repay corporate bonds. Therefore, it is important to look at the real economy rather than just the loan amounts. When assessing tightening through quantity variables, one must be very cautious in interpretation.

- There are mentions that the timing for inflation to converge to the target level may be delayed. How did you consider the developments of the Middle East conflict in this policy decision process?

▲ It is difficult to predict what will happen with the Israel-Hamas conflict. The next few weeks will be very important. It is hard to say which scenario fits best at this point. However, regardless of what happens, the consensus among the Monetary Policy Committee members is that the pace of inflation decline will likely be slower than the path predicted in August. When asked whether inflation will reach 2% by the end of December next year, there is significant uncertainty. We expected convergence to that level, but the pace is anticipated to be slower than predicted in August.

- In a recent foreign media interview, when asked about the possibility of raising the neutral interest rate, you responded that "Korea is atypical and in a special situation due to the decline in potential growth rate." Does this imply consideration of a downward adjustment of the neutral rate due to the decline in potential growth? If so, a lower neutral rate could be interpreted as a signal for monetary policy easing in the future, perhaps next year.

▲ This has been a continuous discussion. Overall, regarding U.S. monetary policy, there is debate at the IMF and G20 about whether the neutral rate in the U.S. will rise due to expectations of higher sustained interest rates and a stronger-than-expected economy. Over the past month, U.S. medium- to long-term bond yields have risen significantly, and Korean medium- to long-term bond yields have risen alongside them. While the Bank of Korea adjusts short-term rates, medium- to long-term rates have moved in tandem with U.S. rates. This is concerning because, theoretically, under a floating exchange rate system where the exchange rate moves freely, monetary policy should be independent from foreign influences. Despite maintaining a floating exchange rate system, we have observed synchronization of medium- to long-term rates with U.S. rates, which is troubling. This is not just a short-term phenomenon; even if the U.S. neutral rate rises due to a strong economy, Korea’s potential growth rate is declining due to population aging over a 10- to 20-year horizon, which could lead to a declining equilibrium interest rate. While advanced countries may see an increase, Korea may experience a decrease. It is theoretically intriguing whether Korea can independently lower rates or will be influenced by external factors. The answer is unclear. We have discussed this with the IMF, BIS, and global experts, who all agree it is a good question but are uncertain about the answer. We will continue to explore this. However, I was surprised by many reactions suggesting that this implies signaling a monetary policy easing by lowering the neutral rate in the past few months. The current neutral rate is based on growth and inflation forecasts for the next 1-2 years, not on 10- or 20-year projections. Interpreting long-term issues as influencing immediate rate adjustments is an overreaction. I hope to distinguish between medium- to long-term and short-term issues.

- The Bank of Korea forecasts China’s growth rate at 4.5% next year, while the IMF projects 4.2%. What specifically causes this difference? Given recent signs of economic improvement amid recession, how do you evaluate this?

▲ The average forecast for China’s growth rate next year by institutions like IB is around 4.5%. The IMF’s 4.2% is somewhat lower. We discussed various views on this, including issues related to the real estate market. However, after the IMF’s announcement, China has implemented stimulus policies, and this quarter’s economic growth rate came out higher than expected, so we need to assess the implications. We will provide the assumptions when we announce the economic growth forecast in November.

- With only a few months left this year, what are the Monetary Policy Committee members’ interest rate outlooks for the next three months?

▲ Among the six Monetary Policy Committee members excluding myself, one suggested that due to the high uncertainty in policy conditions, flexibility should be maintained to either raise or lower the base rate in the next three months. The other five acknowledged the high uncertainty but judged that inflationary pressures have increased and the timing for inflation to converge to the target is likely delayed compared to August. Therefore, they believe there is a greater need to strengthen tightening and keep the possibility of further rate hikes open. Among those five, one emphasized the need for preemptive measures to prevent further deterioration of household debt.

- Please provide specific reasons for your recent mention that the U.S. rate hikes are nearly over.

▲ First, the market previously did not believe the Federal Reserve’s statements and expected rate cuts soon. However, with the U.S. economy and labor market remaining strong, the market now assumes no rate cuts in the near term. Some interpret the reduced demand for long-term bonds and rising yields as a result of this changed expectation. Second, the U.S. fiscal deficit remains above 6%, with ongoing wars and no political consensus to reduce social welfare spending, which affects funding and pushes rates up. Last month, U.S. Treasury yields fell due to the Israel-Hamas conflict but then rose again. Opinions are divided on how this will affect the Fed’s rate decision in early November. Some believe no further hikes are needed given already high market rates, while others argue that strong economic conditions and the conflict may push inflation higher, necessitating further hikes. Saying the U.S. rate hike cycle is ending does not mean no hikes but rather that the pace of hikes is stabilizing compared to last year.

- In September, inflation rates in both Korea and the U.S. were 3.7%. Given that the U.S. peak last year was 9.1% and Korea’s was 6.3%, Korea’s inflation slowdown appears slower. Korea is suppressing electricity rate hikes, unlike the U.S. with stronger demand. Why is Korea’s inflation deceleration slower?

▲ When coming down from a higher level, the decline is faster; from a lower level, it is slower. Both countries have the same target, but the U.S. started from a much higher level, so its decline is faster. Korea’s convergence to the 2% target is expected to be faster than the U.S. Additionally, the U.S. raised rates by over 500 basis points, while Korea raised only about 300 basis points. The U.S. has many fixed-rate loans, whereas Korea has mostly short-term variable rates, so the impact differs. Therefore, judging speed solely by these factors is difficult.

- Regarding real estate, you recently mentioned that Korea has somewhat achieved a soft landing. Today, you said concerns about non-bank financial institutions have eased but potential risks remain. How do you view the previously heated real estate PF (Project Financing) risk issue?

▲ When rates started rising sharply late last year, we did not expect real estate PF to become a major problem by year-end. By September or October, we anticipated difficulties would begin for highly leveraged institutions heavily invested in real estate PF. However, concerns about real estate PF escalated, causing a strong market reaction. We worried that if control failed, it could affect financial stability, with prices potentially dropping 20-30% from the peak. However, since inflation was rising, we could not avoid raising rates and eased some microprudential regulations. As a result, real estate prices fell about 15% in the first half of this year, which we described as a soft landing. Transaction volumes increased, and prices in some metropolitan areas rose. Overall, we do not judge based solely on specific regions, so rising real estate prices do not mean PF risks are gone. The government led major creditors to quietly restructure about 10% of roughly 200 real estate PF projects. Problems from interest rate burdens on real estate PF may still emerge gradually. The government’s stance is to manage these PF risks carefully to avoid major shocks.

- The Korea-U.S. interest rate differential has been inverted for 15 months. Is this a concern?

▲ No economic theory states that the interest rate differential alone determines market movements. Past experience also does not support this. Expectations about changes and their acceleration matter more. Therefore, the interest rate differential itself should not be a policy target. There is no theory that says the current 2 percentage point gap must be reduced to 1 percentage point for safety. We should assess the situation as it evolves.

- You hinted at the possibility of raising inflation forecasts. If this is not due to the Israel-Hamas war, what other factors are involved? If the situation worsens significantly, causing high inflation and poor growth, where would you place emphasis?

▲ Even before the war, oil prices rose significantly, more than we expected. Oil prices were the biggest factor. We will announce new forecasts in November but have not yet decided on the baseline scenario. We need to observe the coming weeks. In principle, the focus should be on core inflation, which is the textbook answer. However, the Monetary Policy Committee members were divided 5 to 1 on this. Deciding where to place weight requires not just principles but also growth and inflation figures.

- One Monetary Policy Committee member mentioned a rate cut option. There are also comments that the opportunity for further rate hikes was missed.

▲ Due to high uncertainty, the member suggested keeping both rate hike and cut options open. The other five members, considering overall uncertainty, judged that inflation risks are higher and thus kept the door open for hikes. If inflation paths change significantly and expected inflation shifts, we may raise rates despite economic sacrifices. We must consider preconditions. The Committee and I have principles and have stated how we would respond if outcomes deviate from expectations. Therefore, I do not think we missed an opportunity. We will respond based on incoming data.