Lee Chang-yong "Timing of Interest Rate Cut, Uncertainty Grows Larger" [Q&A]

Bank of Korea May Monetary Policy Meeting Press Conference
"Uncertainty Grows Over Timing of Interest Rate Cuts in Second Half"
Economic Growth Rate Revised Upward, Mostly Due to Net Exports
Inflation Growth Rate Rises at Second Decimal Place

[Image source=Yonhap News]

Lee Chang-yong, Governor of the Bank of Korea, stated on the 23rd that the uncertainty regarding the timing of interest rate cuts in the second half of the year has significantly increased. Regarding the necessity of lowering interest rates, he said, "If inflation stabilizes to a certain level, it is desirable to normalize the previously restrictive interest rate levels."

At a press conference held immediately after the Bank of Korea's Monetary Policy Committee decided to keep the base interest rate unchanged for the 11th consecutive time (at 3.5% per annum), Governor Lee said, "The current restrictive interest rate level is working to reduce inflation," and added, "Once we are confident that inflation is fully stabilized, a process to normalize the restrictive interest rate level will be necessary."

Regarding the upward revision of the economic growth rate to 2.5% while maintaining the previous inflation forecast, he explained, "About three-quarters of the increase in the growth rate adjustment came from net exports." Governor Lee further explained, "Due to favorable winter weather, energy imports decreased, and semiconductor investment delays led to a reduction in equipment investment imports."

However, he noted that the inflation rate forecast increased in the second decimal place. Governor Lee said, "There was considerable impact on the second decimal place due to inflationary pressures during the revision of the growth forecast, but it was not enough to change the first decimal place."

When asked if domestic demand had improved, he replied, "It is better than expected, but not better compared to the overall growth rate," adding, "The construction sector is still in the negative."

Regarding opinions on interest rate cuts within three months, he said, "One member, as before, suggested keeping the possibility of a rate cut open," and added, "Although inflationary pressures have increased, domestic demand recovery is expected to be gradual, and inflation is expected to continue its deceleration trend. Considering the lag effect of monetary policy, it was suggested to keep open the possibility of a preemptive rate cut."

Below is a Q&A session with Governor Lee.

- In this economic outlook, the growth forecast for this year was significantly raised. It seems the need for interest rate cuts has decreased. What is your view?

▲ There is still some expectation for rate cuts in the second half due to upward inflationary pressures, but the uncertainty about the timing of cuts has greatly increased.

- Growth is expected to exceed 2% next year as well. What do you see as the main reason for needing to cut rates?

▲ The current interest rate is at a restrictive level and is working to continue lowering inflation. If inflation stabilizes to the desired level, it is appropriate to normalize the previously restrictive interest rate level. Since the economy is not overheating excessively, normalizing rates is natural.

▲ The current growth rate is expected at 2.5%, but consumption is at 1.8%, showing a large gap between domestic demand and exports. There is also significant polarization within domestic demand. Therefore, once we are confident that inflation is fully stabilized, a process to normalize the restrictive interest rate level will be necessary.

- At the last Monetary Policy Committee meeting, there was an opinion to keep the possibility of a rate cut within three months in mind. Has this view changed after the first-quarter growth flash estimate and revised economic outlook?

▲ One member, as before, suggested keeping the possibility of a rate cut open. The other five members expressed the view that it is appropriate to maintain the rate at 3.5% even after three months. The reason for maintaining is that inflation is expected to continue decelerating, but due to increased inflation uncertainty, it is necessary to observe until inflation converges to the target level.

▲ The member who suggested keeping the possibility of a cut open acknowledged that inflationary pressures have increased, but since domestic demand recovery is expected to be gradual and inflation is expected to continue decelerating, considering the lag effect of monetary policy, it was suggested to keep open the possibility of a preemptive rate cut.

- Was there any discussion about the possibility of further base rate hikes at the Monetary Policy Committee meeting?

▲ If inflation rises decisively, yes, but under current circumstances, the possibility is limited.

- Emerging markets in South America and Europe are clearly lowering rates to stimulate their economies. There are forecasts that preemptive rate cuts might be possible earlier than in the U.S. What are your thoughts on this?

▲ Countries like Sweden, Switzerland, and South America are lowering rates first because signals have come that the U.S. will no longer raise rates and may cut them, so each country is adjusting monetary policy according to their own situations.

▲ Sweden's economy is in negative territory, and household debt issues led them to start lowering rates quickly. Switzerland began lowering rates because inflation stabilized around 1%. South America has very high inflation levels, so direct comparisons are difficult. The interest rate gap naturally affects exchange rates. How the interest rate gap with the U.S. affects exchange rates is not something to consider mechanically; rather, we will review potential problems if the gap widens excessively and proceed with monetary policy in the second half accordingly.

- During your ADB trip, you mentioned three assumptions had changed compared to April. Are these still valid? The market is interpreting this as a full reconsideration of rate cuts.

▲ After the April Monetary Policy Committee meeting, during the ADB trip, I mentioned three news items: one was the delay in U.S. rate cuts and better-than-expected first-quarter indicators; another was the Iran-Israel conflict risk causing exchange rate spikes. Some interpreted the rate cut possibility hinted at during the meeting as causing exchange rate volatility, but I think this is an overly domestic-focused interpretation. It is not solely due to domestic factors.

▲ Many say it's a full reconsideration, but more precisely, it means reviewing the numbers. Since domestic growth increased, we significantly raised the economic growth forecast. However, the impact on inflation was limited. Fortunately, geopolitical risks have recently calmed but could change anytime.

▲ It is difficult to say how the delay in U.S. monetary policy will unfold. Yesterday's FOMC minutes mentioned the need to raise rates, but globally, the timing of the U.S. pivot will influence markets. In that sense, considering various factors in this Monetary Policy Committee meeting, I used the expression that the timing of rate cuts has become uncertain.

- Fundamentally, do you think domestic demand has improved?

▲ It is better than expected, but not better compared to overall GDP growth. For example, domestic demand was adjusted from about 1.6% to 1.8%, but the construction sector remains negative. Domestic demand improved more than expected in April, and I think it is fair to say domestic demand is not that bad. I hope this trend continues.

- Interest rate differentiation has begun outside the U.S. At the last press conference, you mentioned conditions for decoupling were created. Is it possible for Korea to differentiate its rates from the U.S.?

▲ In principle, since U.S. monetary policy has changed, the possibility of differentiation has increased, but exchange rate changes and capital flows due to U.S. economic policy still have a greater impact. It is not desirable to mechanically follow the U.S., but we will consider the effects on exchange rates, capital mobility, domestic markets, and ultimately inflation.

- At the April Monetary Policy Committee meeting, you said it was difficult to predict rate cuts in the second half and described it as a period of "deciding whether or not to turn on the blinker." Do you still hold the same view?

▲ It seems like a question implying that growth has risen considerably and monetary policy is being reconsidered from scratch, but the policy direction hasn't changed much. However, the increase from 2.1% to 2.5% in growth is a significant change. Inflationary pressure increased but not enough to change the inflation forecast itself, which is also big news. I think uncertainty about the timing of rate cuts in the second half has increased compared to April and May.

- You judged the current interest rate level as restrictive and said normalization is necessary. Looking at market conditions, money supply growth is steep. Mortgage loan rates have fallen to levels when the base rate was 1.75%. The market views financial conditions as excessively accommodative relative to the interest rate level.

▲ Considering rate cuts depends on whether inflation moves as expected and the timing. It does not mean rate cuts will happen in the second half.

▲ Regarding money supply and mortgage loans, the market sees them as accommodative. However, mortgage loans are repetitive, and the market prefers safer lending compared to project financing, so it is difficult to judge solely by mortgage loans. Considering financial condition indices we monitor, conditions are still restrictive. The key to tightening is real housing prices. Financial conditions are easing but still in a restrictive state. Consumer Price Index (CPI) continues to fall, and core inflation is declining, so the current level is still considered restrictive.

- With the upward revision of the economic growth forecast, the GDP gap turning positive is expected to be earlier. When do you expect this to happen?

▲ With the raised growth forecast, we expect the GDP gap to turn positive early next year.

- A month has passed since the first-quarter economic growth rate was announced. Has the cause of the surprising domestic demand improvement been identified?

▲ The difference in the first-quarter forecast was mainly due to missing about three-quarters of the external factors. While exports were better than expected, we missed the reduction in energy imports due to weather and the decrease in semiconductor imports. Customs data is not immediately available, so some parts were missed.

▲ Domestic demand was pulled forward by mobile phone launches. The effect of phone launches and increased government transfer payments influenced consumption, but government fiscal data is received late, so the increase in transfer payments affecting consumption was missed. Weather effects also played a role.

- Generally, raising economic growth leads to higher inflation. What is the background for maintaining the inflation forecast? Domestic demand showed a temporary growth in Q1; do you expect weakness afterward?

▲ Despite raising growth from 2.1% to 2.5%, inflation was maintained mainly because about three-quarters of the growth increase came from net exports. Favorable winter weather reduced energy imports, and semiconductor investment delays reduced equipment investment imports. These were temporary factors.

▲ Domestic demand was higher than expected, but annual consumption growth is forecast at about 1.8%, which is more moderate than the 2.5% economic growth. Therefore, domestic demand is expected to limit inflationary pressures. Also, government measures like extending energy taxes were reviewed and found not large enough to change forecasts.

▲ However, the inflation forecast increased significantly in the second decimal place. Inflationary pressures during the growth forecast revision affected the second decimal place considerably but not enough to change the first decimal place.

- The Monetary Policy Committee statement said, "Domestic inflation will face upward pressure due to improved growth, but the impact will not be large due to gradual consumption recovery." What does this specifically mean?

▲ Since the GDP gap has narrowed, there is upward inflation pressure, but it is not large enough to change the annual inflation forecast of 2.6%. The government also offsets some of this with inflation policies. In this economic outlook, the second-half inflation forecast was raised from 2.3% to 2.4%. Looking at consumption growth, inflation is slightly higher but is expected to decline as forecasted.

- Globally, neutral interest rates are rising. Do you think Korea's neutral rate could decline due to demographic factors? How has Korea's neutral rate changed since COVID-19?

▲ We cannot exclude the possibility that Korea's neutral rate may decline. We plan to hold a conference on neutral interest rates at the end of this month. I hope it will be an academic forum to discuss this topic.

▲ It is time to academically discuss the difference between neutral rates considering financial stability and those that do not. You will hear more answers at the upcoming conference.

- The Bank of Korea's first-quarter forecast was significantly off. Has there been a similar case of more than double the forecast error in the past? Has the review for reliable forecasting been completed?

▲ We are discussing with the government whether we can receive data faster and if customs data can be accessed through other channels. Previously, credit cards were widely used, but recently digital wallets have become more common, so we are trying to reflect changes due to technological progress.

▲ Of course, we must humbly improve when forecasts fail or lose credibility. Personally, I want to emphasize that revising forecasts by about 0.4% is common. The IMF also raised the U.S. forecast from 2.1% in January to 2.7% in April, a 0.6% increase. Japan lowered its forecast from 1.2% to 0.8%, a 0.4% decrease. Forecasting is not an exact science, so errors occur. The important process is to discuss why differences occurred and how policies changed accordingly.

▲ Some say not to release statistics when forecasts are wrong. Changing the dot plot shocks markets and causes confusion, so domestic reports advise against conflicting actions. I have never heard this overseas. Did the market get disrupted by today's 0.4% growth forecast revision? The announcement is part of the adjustment process and does not reduce credibility.

▲ In Korea, strangely, the Bank of Korea's forecast errors are viewed negatively. I have not heard such criticism abroad. If the Bank of Korea did not release data, it might stabilize markets and avoid criticism. But as Governor, I do not want that. When forecasts deviate, discussing what was wrong and how to improve reveals who the more competent staff are. My successor may have a different philosophy, but while I am here, I believe it is better for the Bank of Korea to communicate more and provide information to improve. We will strive to produce better quarterly data to be released in August.

- The flash estimate showed private consumption was better than expected. Is there a possibility that GDP will be revised downward in the final estimate?

▲ Consumption was indeed better than expected. This year, consumption growth forecast was raised from 1.6% to 1.8%. This is good news. However, some temporary factors must be considered regarding sustainability. We expect some adjustment in Q2, followed by growth resumption in Q3.

▲ However, the consumption recovery is still lagging behind overall GDP growth of 2.5%, and there is polarization within domestic demand. We are monitoring how this develops.

▲ Based on experience, the difference between flash and final estimates has not been large. We do not expect the trend to change.

- You said the timing of rate cuts in the second half is uncertain but still under consideration. Could the magnitude of rate cuts also change?

▲ We have not discussed the magnitude yet. We will confirm the timing first and then discuss the magnitude. Naturally, the magnitude will change. The neutral rate considering financial stability differs from that without such consideration. From our perspective, inflation is the biggest variable before it is controlled. At this point, timing comes before magnitude.