[Initial Perspective] Excessive Expectations for Interest Rate Cuts... Bank of Korea Faces the Test

"It was not something Chairman Powell said. He just said what people wanted to hear." (Ostan Goolsby, President of the Chicago Federal Reserve Bank)

The aftermath of the last U.S. Federal Open Market Committee (FOMC) meeting of the year continues. After Jerome Powell, Chairman of the Federal Reserve (Fed), hinted at the end of interest rate hikes at the U.S. FOMC, expectations quickly spread that the timing of the monetary policy shift could come earlier than initially anticipated. However, Fed officials belatedly pushed back, calling it a 'market misinterpretation' and moved to curb these expectations.

The market immediately cheered Powell's dovish remarks, but concerns are mounting that current market expectations for rate cuts next year are excessive. As Fed officials continue to manage expectations daily, they are making statements about a market that only listens to 'what it wants to hear.' Although U.S. inflation is slowing rapidly, the labor market remains robust, and expected inflation rates have not declined, leading to assessments that premature celebrations are unwarranted. Even considering monetary policy changes in major countries due to global supply chain shifts, it is viewed as difficult to return to a pre-COVID-19 environment in the short term. Even if rate cuts occur as the market expects next year, the dot plot still indicates rates in the mid-to-high 4% range. This implies that a return to the 'low interest rate' environment of the past is unlikely.

Changes in the Fed's monetary easing policy are expected to inevitably affect South Korea's monetary policy as well. First, expectations that Korea could cut rates before the U.S. have been completely dashed. The first half of next year's monetary policy is likely to see a tug-of-war between the market, which expects rate cuts, and the Bank of Korea (BOK), which prioritizes price stability. There is growing consensus that after confirming the U.S. cuts policy rates in the second quarter, Korea will follow suit around the third quarter. The BOK has warned against premature market expectations, stating, "At present, there is no change in the policy direction to maintain a sufficiently long tightening stance until inflation converges to the target level."

Unlike the U.S., which is showing a rapid disinflation trend, South Korea's disinflation pace is relatively slow, acting as a constraint on monetary policy decisions. Since inflation is expected to exceed the current forecast path and the stabilization at the target level is delayed, the current high interest rate stance may be prolonged. Increasing private (household and corporate) debt is a particular variable. According to the minutes of the Monetary Policy Board meeting released the previous day, one board member warned, "Despite high interest rate conditions, household and corporate loan growth continues, increasing the need for macro leverage (borrowing) management."

The financial stability situation is also challenging. The Legoland crisis, which shook financial markets in the second half of last year, was narrowly averted through government liquidity supply and maturity extensions, but it is re-emerging as a financial instability factor one year later. As project financing (PF) default risks intensify, some express regret that if restructuring had begun a year ago, it could have been a golden opportunity to address rising housing prices and surging household debt.

Ben Bernanke, former Fed Chairman, emphasized in his book "21st Century Monetary Policy" that "the Fed must demonstrate that its non-political, independent, and objective policy decision-making process benefits the economy in the long term." While the Fed will undoubtedly make mistakes in the future as it has in the past, as Jerome Powell said, it must continue to show that it does not err in character and integrity. This is a point the Bank of Korea, facing a monetary policy transition next year, must not forget.

Lee Chang-yong, Governor of the Bank of Korea, is holding a press conference after the Monetary Policy Direction Decision Meeting of the Monetary Policy Committee held at the Bank of Korea in Jung-gu, Seoul on the 30th of last month. Photo by Joint Press Corps