One Day Before the FOMC, 0.25%p Base Rate Hike Likely... Will the Soaring Exchange Rate Become a Hidden Threat?

First Ever Four Consecutive Interest Rate Hikes Initiated

Bank of Korea Governor Lee Chang-yong is answering questions from the press at the Monetary Policy Direction press conference held at the Bank of Korea in Jung-gu, Seoul on July 13. Photo by Kang Jin-hyung aymsdream@

[Asia Economy Reporter Seo So-jeong] As the Bank of Korea's Monetary Policy Committee is scheduled to decide the base interest rate on the 25th, the market expects the rate to rise by another 0.25 percentage points, reaching an annual rate of 2.50%. If the Bank of Korea raises rates again this month, it would be the first time in history that rates have been increased four consecutive times (April, May, July, August).

According to the financial market on the 24th, most economic experts anticipate that the Monetary Policy Committee will follow the existing forward guidance on the 25th and implement a 'baby step' (a 0.25 percentage point increase in the base interest rate). This is because global inflationary pressures remain severe, and domestic prices are also soaring, making 'controlling inflation' the top priority.

Right after the July Monetary Policy Committee meeting, Bank of Korea Governor Lee Chang-yong stated, "If the domestic inflation trend does not significantly deviate from the current forecast path, it is desirable to gradually raise the interest rate by 0.25 percentage points for the time being." The Monetary Policy Committee, which implemented the first-ever big step (a 0.50 percentage point increase) last month, had dismissed the possibility of another big step in August.

Although expectations for the peak of inflation have grown due to recent declines in international oil and grain prices, prices have not fallen easily. The consumer price index in July rose by 6.3% year-on-year, the highest increase in 23 years and 8 months since November 1998 (6.8%), influenced by rising prices of dining out and agricultural, livestock, and fishery products. The Federation of Korean Industries' Korea Economic Research Institute stated, "Due to recent abnormal weather such as high temperatures, droughts, and heavy rains, agricultural yields have been poor, and combined with Chuseok holiday prices, inflation anxiety among economic agents is rapidly spreading," adding, "If expected inflation enters a calming phase, consumer prices are expected to peak in September (7.0%) and then maintain levels between the high 5% and high 6% range."

Expected Inflation Declines but Remains High... Perceived Inflation Rises Due to Heavy Rain

According to the Bank of Korea, the expected inflation rate for the next year fell to 4.3% this month from 4.7% last month, which was the highest ever recorded. Although this is the first decline in expected inflation since December last year, it still remains at a high level in the 4% range. The inflation perception index, which reflects the judgment on consumer price inflation over the past year, remained unchanged at 5.1%. Hwang Hee-jin, head of the Bank of Korea's statistics survey team, explained, "Although oil prices have fallen, prices of food and vegetables have risen recently due to heavy rains," adding, "While expected inflation has declined as the inflation peak is anticipated in the second half of the year, perceived inflation remains high due to rising felt prices."

The situation where the base interest rates of Korea and the United States have reversed also increases the likelihood of a rate hike by the Monetary Policy Committee. The U.S. Federal Reserve (Fed) raised the policy rate by a giant step (0.75 percentage points) consecutively at last month's Federal Open Market Committee (FOMC) meeting, pushing the upper bound of U.S. policy rates to 2.50%, higher than Korea's 2.25%. If the Bank of Korea raises rates by 0.25 percentage points this month, the upper bounds will be equalized, but if the U.S. again takes a big step or giant step next month, the interest rate gap between Korea and the U.S. will widen further. When U.S. rates are higher than Korea's, capital outflows by foreign investors may accelerate.

[Image source=Yonhap News]

In particular, the recent sharp rise in the won-dollar exchange rate is adding inflationary pressure and providing a pretext for rate hikes. Despite verbal intervention by foreign exchange authorities for the first time in two months to curb the relentless rise in the exchange rate, it was insufficient to stop the upward trend. According to the Seoul foreign exchange market, the won-dollar exchange rate closed at 1,345.5 won the previous day, the highest level since the financial crisis. This is the highest record in about 13 years and 4 months since April 29, 2009 (high of 1,357.5 won). Just before the market closed at 3:29 p.m., it even surged to 1,346.6 won. On that day, the exchange rate opened at 1,339.5 won, down 6 won from the previous day, and then moved around the 1,340 won level again.

Jeon Gyu-yeon, a researcher at Hana Securities, said, "Ahead of the Jackson Hole meeting on the 26th (local time), the market has preemptively priced in U.S. tightening, causing the exchange rate to rise, but the level burden has increased," adding, "After strong resistance at the 1,350 won level, it is likely to gradually calm down."

Kim Jeong-sik, honorary professor of economics at Yonsei University, said, "The recent sharp rise in the won-dollar exchange rate acts as upward pressure on already high domestic prices," adding, "When the exchange rate rises, import prices increase, which can further fuel consumer prices, thus increasing the necessity for interest rate hikes."

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