Korea-US Base Rate Inversion... Bank of Korea Faces Deep Concerns Over 'Capital Outflow and Economic Slowdown'

US Fed Giant Step Causes Korea-US Interest Rate Inversion
BOK and Government "In Line with Market Expectations... Limited Impact"
However, Concerns over Capital Outflow Due to Domestic and International Uncertainties
BOK Contemplates Rate Hike Amid Inflation and Economic Slowdown
Low Possibility of Big Step in August... 0.25%p Increase Expected

With the reversal of the Korea-US base interest rates for the first time in two and a half years, attention is focused on what impact this will have on the Korean financial market. The Bank of Korea and the government, citing past cases, believe that the impact of the interest rate inversion on the financial market will be limited. However, concerns are mounting that the damage caused by the interest rate inversion could be greater than in the past due to the recent global inflation surge and supply chain instability, as well as unfavorable domestic and international economic conditions. As major countries including the US rapidly raise interest rates and economic slowdown forecasts gradually increase, the Bank of Korea’s dilemma ahead of next month’s Monetary Policy Committee meeting is deepening.

Government and Bank of Korea: "Limited Impact from US Rate Hike"

On the morning of the 28th, Deputy Prime Minister and Minister of Economy and Finance Choo Kyung-ho and Bank of Korea Governor Lee Chang-yong held an emergency macroeconomic and financial meeting at the Seoul Banking Hall with Financial Services Commission Chairman Kim Ju-hyun and Financial Supervisory Service Governor Lee Bok-hyun to discuss countermeasures against the US Federal Reserve’s giant step. In his opening remarks, Deputy Prime Minister Choo said, "This Fed decision largely aligns with market expectations," and added, "The impact on the domestic financial market is also expected to be limited." Although the US base interest rate has risen above Korea’s, the possibility of foreign capital outflow from Korea is not considered significant.

The Fed raised the base interest rate by 0.75 percentage points at the overnight Federal Open Market Committee (FOMC) meeting, from 1.50-1.75% to 2.25-2.50%, causing an inversion where the US rate surpassed Korea’s base rate of 2.25%. This is the first time in about two and a half years since February 2020 and the fourth time in history that the Korea-US base interest rates have inverted. Previous inversions occurred during June 1996 to March 2001, August 2005 to September 2007, and March 2018 to February 2020.

Deputy Prime Minister Choo noted, "Although there were three previous inversions, foreign securities investment funds actually maintained net inflows," and said, "Economic fundamentals and appropriate responses have a greater impact on capital inflows and outflows." In fact, after the Fed’s rate hike on the day, uncertainty eased somewhat, and the won-dollar exchange rate opened at 1,306.0 won, down 7.3 won from the previous session.

Bank of Korea Governor Lee Chang-yong, Deputy Prime Minister and Minister of Economy and Finance Choo Kyung-ho, Financial Services Commission Chairman Kim Ju-hyun, and Financial Supervisory Service Governor Lee Bok-hyun are taking a commemorative photo on the morning of the 28th at the Bankers' Hall before holding an emergency macroeconomic and financial meeting. (Photo by Bank of Korea)

Double Burden of Inflation and Economy... Difficult to Simply Compare with the Past

However, if major countries including Europe continue their interest rate hike trend, the possibility of foreign capital withdrawing from Korea’s stock and bond markets cannot be ruled out. From an investor’s perspective, there is a stronger incentive to invest in countries with higher interest rates than Korea. Especially, recent global inflation, the Ukraine crisis, supply chain instability, and China’s lockdown measures are unprecedented, making simple comparisons with past cases difficult.

Monetary Policy Committee member Seo Young-kyung said in a lecture the day before, "The fact that other countries’ interest rates are rising quickly means that Korea’s relative returns are falling, so sensitivity to the domestic-foreign interest rate gap may be higher than in the past." Deputy Governor Lee Seung-heon also assessed at the market situation review meeting that "Uncertainty about the speed and magnitude of the Fed’s rate hikes remains, increasing the likelihood of volatility in global financial markets."

Next Month’s Monetary Policy Committee... Possibility of a Big Step by the Bank of Korea

Accordingly, attention is focused on the size of the Bank of Korea’s rate hike decision at next month’s Monetary Policy Committee meeting. The Korea Economic Research Institute analyzed in its report titled ‘Estimation of Appropriate Base Interest Rates for the US and Korea and Implications’ that the US’s appropriate base interest rate is estimated at 3.12%, and if Korea follows the appropriate interest rate gap between the two countries, the domestic base interest rate could rise to 3.65%. This means there is room for an additional 1.4 percentage point increase from the current level. There are only three Monetary Policy Committee meetings scheduled for the rest of the year (August, October, and November). To reach the appropriate interest rate level as analyzed by the Korea Economic Research Institute, all three remaining meetings would need to implement big steps.

However, inside and outside the Bank of Korea, it is considered unlikely that the Monetary Policy Committee will take a big step (a 0.50 percentage point increase in the base rate) immediately next month. Governor Lee said right after the last Monetary Policy Committee meeting, "The interest rate inversion itself is not a problem," and that it is desirable to gradually raise rates by 0.25 percentage points for the time being. Also, the US rate hike magnitude did not immediately exceed expectations.

Projections that inflation will peak in the third quarter and stabilize, along with concerns that an economic recession will fully materialize in the first half of next year, also reduce the possibility of a big step. According to the Bank of Korea on the day, concerns about economic slowdown due to rate hikes in major countries have caused domestic companies’ business sentiment to decline for two consecutive months.

Kim Tae-gi, emeritus professor of economics at Dankook University, said, "The Bank of Korea will continue to raise rates to show its commitment to price stability, but there is no need to necessarily follow the Fed’s giant step." He added, "Our economy’s overall strength has recently weakened significantly, and rapid rate hikes could cause a recession, so aggressive rate increases will be difficult."

This content was produced with the assistance of AI translation services.