[Economy Pulse] The Background of the Bank of Korea's Interest Rate Decision

The Monetary Policy Board of the Bank of Korea decided to keep the base interest rate unchanged at 2.5% on August 28. Despite the fact that economic growth rates for the first and second quarters of this year were only 0% and 0.5%, respectively-well below the potential growth rate of around 2%-the board did not opt to lower rates. The Governor of the Bank of Korea cited concerns over housing price instability and rising household debt as the reasons behind this decision.

This decision presents an opportunity to revisit the monetary policy objectives as stipulated by the Bank of Korea Act. Article 1, Paragraph 1 of the Act specifies price stability as the primary goal, while Paragraph 2, added in 2012, introduces financial stability, and Article 4 calls for harmony with government economic policy. Given that government economic policy primarily aims for economic stabilization, monetary policy is essentially tasked with pursuing three objectives simultaneously: price stability, economic stability, and financial stability. However, it is inherently difficult to achieve all three goals with a single policy tool-interest rates. In particular, when supply shocks or external shocks occur, conflicts between these objectives are inevitable. The recent decision was made amid such a dilemma.

From the perspective of price stability, both the consumer price inflation rate and core inflation rate have hovered around the 2% target since the second half of 2024. Although factors such as tariffs and exchange rates remain, inflation is not currently a major factor in interest rate decisions. In contrast, the economic situation is severe. The economic growth rate is well below the potential rate, and construction investment has declined by double digits compared to the previous year. Therefore, it was only natural that there were calls for a rate cut to stimulate the economy.

Nevertheless, the board opted for a freeze rather than a cut due to concerns over financial stability. Financial stability became an institutionalized policy objective in the wake of the 2008 financial crisis, and prioritizing it is entirely reasonable. However, financial stability is a broad concept encompassing the soundness of household and corporate debt, the smooth functioning of financial markets, and the overall health of the financial system, and there is no single concrete indicator. While it is understandable to try to curb rising housing prices-which can drive up household debt and threaten financial stability-financial stability should not be equated directly with 'housing price stability.' Accumulated household debt, non-performing project financing loans, and rising housing prices in the Seoul metropolitan area certainly affect financial stability, but reducing financial stability to merely 'housing price stability' risks distorting its original intent.

For example, a slump in the construction sector and rising project financing delinquency rates could actually be arguments in favor of a rate cut. In addition, it is well established that policy tools such as tax policy, financial regulation, and supply-side measures are more effective than interest rates in addressing housing price issues. While housing prices in some parts of the Seoul metropolitan area are unstable, the housing market in other regions is suffering from severe stagnation due to unsold inventory. In this context, it is worth questioning whether prioritizing financial stability at the expense of economic stability was the best choice. If the real reason for the rate freeze was concerns over exchange rate instability due to a widening interest rate gap between Korea and the United States, that might have been a more convincing explanation.

This latest decision by the Monetary Policy Board once again demonstrates that monetary policy is a sophisticated process of balancing multiple objectives: price stability, economic stability, and financial stability. While financial stability is undoubtedly a core objective of monetary policy, it should not be interpreted as synonymous with housing prices. Moreover, given the clear slowdown in economic growth, a rate cut was also a viable alternative. Moving forward, the Bank of Korea must avoid overemphasizing any single objective and strive for a balanced approach that assigns reasonable weight to all three goals.

Kwak Noseon, Professor of Economics at Sogang University (Former President of the Korean Finance Association)