[Insight & Opinion] How to Respond to Prolonged High Interest Rates

The timing of interest rate cuts by the U.S. Federal Reserve (Fed) and the Bank of Korea is a matter of great interest to all of us. If interest rates are lowered or quantitative easing is expanded, the economy can recover, and the interest burden caused by high rates can be reduced. Initially, Wall Street expected the timing to be in March this year, then postponed it to May, but after the January Consumer Price Index (CPI) rose to 3.1%, higher than expected, the timing has been pushed back again to June. The Fed’s policy rate and the Bank of Korea’s base rate cuts depend on inflation rates, the possibility of a hard landing in the economy, and the risk of financial distress. Even if inflation does not stabilize at around 2%, if there is a risk of a hard landing or an expansion of financial distress, interest rates must be cut to avoid a financial crisis.

Considering inflation alone, it is likely that rate cuts will be delayed until after June. Although international crude oil prices are expected to fall due to oversupply, inflation could reoccur as service prices rise due to increased housing costs and wage hikes that appear with a time lag. In fact, during the second oil shock in the 1980s, Paul Volcker, then chairman of the Fed, lowered interest rates when inflation was falling, but as the decline in prices slowed and inflation reoccurred, he sharply raised rates again. For this reason, the Fed and the Bank of Korea may be reluctant to cut rates, and even if they do, the cuts may be small. High interest rates are likely to persist. If rate cuts are delayed, concerns arise over a hard landing caused by reduced consumption and investment, and an expansion of financial distress due to high interest burdens and a collapse of the real estate bubble. Policymakers need to respond to the prolonged high interest rate environment caused by delayed rate cuts.

First, even if interest rates cannot be cut, liquidity supply should be increased through quantitative easing. It is not easy for Korea to cut rates first amid concerns about capital outflows when there is a 2 percentage point interest rate gap with the U.S. Especially when the exchange rate is rising as it is now, cutting rates first is risky. Considering the risk of household debt distress and bankruptcies among small business owners and self-employed individuals due to sustained high interest rates, monetary authorities need to increase market liquidity even if they do not cut rates. The Fed also provides a lesson by closely cooperating with the Treasury to manage market liquidity, including the total money supply (M2), so that it does not shrink significantly despite sharply raising rates, thereby preventing a hard landing.

It is also necessary to increase disposable income through tax cuts. Since it is difficult to significantly increase exports now, recovering the domestic economy is essential to prevent financial distress. For this, construction activity and private consumption need to increase, but construction has become difficult despite government deregulation because reconstruction fees have risen sharply due to increased building material costs and wages.

Private consumption is also structurally difficult to increase as disposable income decreases. Interest burdens have increased due to high interest rates, and property taxes, including holding taxes, have risen sharply due to housing price increases. Additionally, health insurance premiums based on housing prices and living costs have also risen, significantly reducing disposable income available for consumption. Reduced consumption leads to decreased corporate investment and bankruptcies among self-employed individuals, shrinking the economy and slowing growth in a vicious cycle. Since it is difficult to lower interest rates independently now, policymakers need to revive consumption by lowering taxes to increase disposable income. It should be noted that U.S. Treasury Secretary Yellen is also guiding a soft landing of the U.S. economy under high interest rates through expansionary fiscal policy according to the ‘Yale macroeconomic paradigm.’

If high interest rates persist, the Korean economy faces risks of deepening recession and increased financial distress. Policymakers must recover the domestic economy by increasing liquidity supply and raising disposable income through tax cuts under high interest rates to prevent the Korean economy from being exposed to financial crisis risks. Now, more than ever, the right policy choices to respond to prolonged high interest rates are crucial.

Kim Jeongsik, Professor Emeritus, Department of Economics, Yonsei University