[금통위poll]② Korean Interest Rate Cut Depends on Reaching Inflation Target and US Pivot Timing

End of Major Countries' Tightening Cycles... Timing of US Rate Cuts Crucial
Clear Signal Needed for Inflation Target Achievement
Speed Likely Gradual Considering Interest Rate Differentials
Real Estate PF Issues Cannot Be Ignored

As the interest rate hike cycles of major countries come to an end, market attention is focused on the pivot timing of South Korea, with experts largely agreeing that the biggest variables in the Bank of Korea's (BOK) interest rate decisions will be the timing of reaching the 'last mile' of inflation rate (the final phase toward the target) and the timing of the U.S. interest rate cuts. Since the BOK is increasingly likely to decide monetary policy based on domestic conditions, a clear sign of inflation slowdown is necessary. Additionally, recent project financing (PF) risks combined with a cold economic climate in the real estate market and economic growth rates were also cited as influential factors.

[Image source=Yonhap News]

Interest Rate Cuts to Follow the U.S. in Q3

According to a survey conducted by Asia Economy from the 3rd to the 5th among 21 economists from economic research institutes and analysts from domestic and foreign securities firms, the majority of experts cited 'consumer prices and international oil prices' (11 respondents) as the key variables for the BOK's future monetary policy (multiple answers allowed). The 'timing of U.S. interest rate cuts' was next with 10 votes. Economic growth rate (5) and real estate market conditions (4) were also mentioned. Some experts also pointed to household debt, the interest rate gap between Korea and the U.S., and the general election.

With U.S. interest rate cuts almost certain within the year, experts expect the timing of the Federal Reserve's (Fed) rate cuts to significantly influence South Korea's pivot timing. Seok-tae Oh, an economist at Soci?t? G?n?rale Korea, said, "When the U.S. rate cuts become a reality, it will be difficult for the Bank of Korea to 'hold out' without lowering rates."

Jina Kim, a researcher at Eugene Investment & Securities, added, "The timing of the U.S. rate cuts is important because global inflation and the trend toward a soft landing of the economy are interconnected. The increased correlation between the financial markets of the two countries since the COVID-19 pandemic is also related to the rising synchronization of monetary policies."

According to the Chicago Mercantile Exchange (CME) FedWatch, the probability of the Fed lowering rates at the May Federal Open Market Committee (FOMC) meeting is 92.3%, and the probability for June is 99.7%. In this survey, the majority of experts (16) also viewed the timing of U.S. rate cuts as the second quarter of this year. Considering that Korea's monetary policy is not independent of the U.S., it is expected that the BOK's rate cuts will only be possible after this period. Among the 16 respondents who predicted U.S. cuts in Q2, 14 expected Korea's cuts in Q3.

However, due to the historically large inverted interest rate gap between Korea and the U.S. (2 percentage points), rapid rate cuts are unlikely. If the large inversion of domestic and foreign interest rates continues, the capital procurement costs for Korean economic agents will rise, and currency hedging costs for overseas investments may increase, potentially causing instability in financial markets. Sung-soo Kim, a researcher at Hanwha Investment & Securities, explained, "Even if the U.S. cuts rates more aggressively than expected, we need to pay attention to the inverted interest rate gap. Just as we did not follow the U.S. to the very end during the rate hike cycle, we do not necessarily have to cut rates just because the U.S. does." Yong-gu Cho, a research fellow at Shin Young Securities, also said, "Depending on the timing and speed of U.S. cuts, Korea is likely to follow by gradually narrowing the interest rate gap."

The Battle with Inflation's 'Last Mile' Is Key

Experts predict that consumer prices, which remain at a high level, will be the biggest variable in determining the BOK's monetary policy direction. Since the tightening cycles of major countries are ending, a clear slowdown in consumer prices could provide the BOK with an opportunity to pivot.

Jaekyun Ahn, a researcher at Shinhan Investment Corp., explained, "For the past two years, the biggest variable in domestic monetary policy was the U.S., but as the timing of U.S. rate cuts is moving forward, domestic growth and inflation paths have become more important starting this year."

Bank of Korea Governor Chang-yong Lee recently indicated that future policy decisions will focus more on domestic conditions. In his New Year's address this year, he said, "Unlike last year when most central banks moved in one direction to respond to high inflation, this year, as the interest rate hike cycles of major countries come to an end, policies are expected to diverge by country. The Bank of Korea also has greater room to decide policies with more weight on our internal conditions."

In a survey conducted before last year's final Monetary Policy Committee meeting, 17 respondents cited consumer prices (9) and international oil prices (8) as key variables for monetary policy. Although the soaring inflation trend has recently slowed, the pace is not fast enough, increasing the BOK's concerns. The consumer price inflation rate, which was in the 2% range in July last year, stayed in the 3% range for five consecutive months from August (3.4%) through December (3.2%), including September (3.7%), October (3.8%), and November (3.3%).

Although the inflation rate is moving toward the target level, early rate cuts seem difficult due to various uncertainties about the arrival timing. At the BOK's inflation status review meeting last month, Deputy Governor Woong Kim said, "Inflation is expected to continue slowing, but the pace will be gradual," adding, "There are significant uncertainties related to oil and agricultural product price trends, domestic and international economic conditions, and accumulated cost pressures in the future inflation outlook."

"If Real Estate PF Risks Spread, Monetary Policy Will Also Be Affected"

Recent real estate PF risks, highlighted by Taeyoung Construction's workout application, and the real estate market itself are major variables affecting financial markets. Compared to the 'Legoland incident' in September 2022, the immediate ripple effect on the financial sector seems limited, but the possibility of risk spreading to domestic construction companies cannot be completely ruled out. Yeo-sam Yoon, a researcher at Meritz Securities, mentioned, "Depending on the intensity of domestic real estate restructuring, it could spread as economic and financial risks, requiring a response from monetary policy authorities." Yeha Ahn, a researcher at Kiwoom Securities, also said, "The timing and magnitude of rate cuts may vary depending on the impact of real estate PF and economic direction."

Jaehyung Lee, a researcher at Yuanta Securities who answered that predicting the timing of Korea-U.S. rate cuts is difficult, said, "Domestic and international real estate market conditions affect dollar funding conditions, credit supply capacity of financial institutions, and stability of the funding market," and predicted, "The shift to a rate cut stance will occur when credit and liquidity risks become prominent."