[Financial Planning for the 100-Year Life] Differences in Interest Rate Forecasts Between the Market and Central Banks

There is currently a significant gap between market and central bank interest rate forecasts. This gap is expected to narrow as inflation rates decline in the future.

The U.S. Federal Reserve (Fed) announced at the Federal Open Market Committee (FOMC) meeting in December last year that it would lower interest rates this year. The median federal funds rate for this year, as shown in the dot plot, was 4.5%. However, the market (Chicago futures market Fed Watch Tool) expects the Fed to cut rates six times by 0.25 percentage points each starting from March this year. This implies that the benchmark interest rate will reach 4% by the end of the year.

Reflecting this, the 10-year Treasury yield, which represents market interest rates, recently fell to 3.9%, below the benchmark rate. The short-term 2-year Treasury yield also dropped to around 4.2%.

This financial market situation is unfolding similarly in South Korea. The Bank of Korea (BOK) decided to keep the benchmark interest rate at 3.50% at the January monetary policy meeting held for the first time this year. BOK Governor Lee Chang-yong stated at the press conference following the meeting that there are no Monetary Policy Committee members advocating for a rate cut within the next three months. In particular, Governor Lee, while emphasizing that it was his personal view, forecasted that a rate cut within six months would be difficult.

However, the market is already pricing in rate cuts. Major market interest rates have fallen below the benchmark rate since mid-December last year. The 10-year government bond yield recently dropped to around 3.2%. The short-term 1-year government bond yield also fell to 3.4%, below the benchmark rate.

So how will the gap between the BOK and market expectations narrow? The answer likely lies in the inflation rate. The BOK sees that while the inflation rate continues a trend of underlying deceleration, it remains at a high level and the uncertainty of forecasts is significant, so maintaining the current tightening stance while reviewing domestic and external policy conditions is appropriate.

Last year, the consumer price inflation rate was 3.6%. Although this is lower than the 5.1% in 2022, it is still above the 2% target set by the BOK’s monetary policy. As the BOK mentioned, there is high uncertainty in inflation forecasts. It is difficult to predict the domestic consumption and overall domestic economy, and externally, there is even greater uncertainty regarding international oil prices and raw material costs.

However, the market expects inflation to slow down. Inflation can be forecasted using the spread between long-term and short-term interest rates (= the difference between the 10-year government bond yield and the 1-day unsecured call rate). Analyzing data from January 2010 to December 2023 shows that the long-short term interest rate spread led the consumer price inflation rate by 9 months (correlation coefficient 0.58). Causality analysis also showed that the long-short term interest rate spread unilaterally explained the consumer price inflation rate.

In December, the 10-year government bond yield was 3.42%, lower than the call rate of 3.64% (both monthly averages). Such an inversion of interest rates last occurred from June to September 2019, just before the economy plunged into a severe recession due to COVID-19. This phenomenon also briefly appeared in March-April last year. It is an abnormal situation.

As seen in the lagged correlation analysis, the inversion of the long-short term interest rate spread signals that inflation will significantly decrease nine months later. Assuming the market is correct, it is more likely that the BOK will lower the benchmark interest rate to normalize the long-short term interest rate spread rather than market interest rates rising.

A preemptive monetary policy is desirable because changes in the benchmark interest rate affect various economic indicators such as consumption and investment with a time lag. The BOK currently describes its monetary policy stance as tightening. This could mean that the current benchmark interest rate is higher than the appropriate level. Waiting to cut rates until the consumer price inflation rate settles at 2% would be a delayed monetary policy.

For reference, when the long-short term interest rate spread widened, the KOSPI (year-on-year monthly growth rate) also rose. This means that stock market participants need to closely monitor this indicator.

Kim Young-ik, Adjunct Professor, Graduate School of Economics, Sogang University