Will the Big Step, said to be absent until the end of the year, happen once more?

Lee Chang-yong Faces Deepening Concerns Over US-Korea Interest Rate Reversal
Interest Rate Hike Speed Adjustment Inevitable

Forward Guidance Change Expected After Emergency Macroeconomic Financial Meeting

[Image source=Yonhap News]

[Asia Economy Reporter Seo So-jung] As fears of aggressive tightening by the U.S. materialize, the possibility of the Bank of Korea’s second big step (a 0.50 percentage point hike in the base interest rate) is rapidly rising. The Bank of Korea, which executed its first-ever big step in July, had dismissed the possibility of an additional big step by the end of the year. However, as the U.S. Federal Reserve (Fed) tightened its policy more aggressively, causing the interest rate gap between Korea and the U.S. to widen, urgent action has become necessary.

On the 21st (local time), the Fed took a third giant step by raising the base interest rate by 0.75% at the Federal Open Market Committee (FOMC) regular meeting, drawing market attention to the Monetary Policy Committee meeting scheduled for the 12th of next month. With the interest rates between Korea and the U.S. reversing within a month and the gap expected to exceed 1.0 percentage point by year-end, adjusting the pace of rate hikes has become inevitable.

In July, when the Fed took another giant step, the U.S. base interest rate (2.25?2.50%) surpassed Korea’s (2.25%) for the first time in about two and a half years. Last month, the Bank of Korea raised its base rate by 0.25%, equalizing the upper limit of the Korea-U.S. interest rates. However, with the U.S. taking another giant step overnight, the current upper limit of U.S. interest rates is 0.75 percentage points higher than Korea’s.

Given that the Fed has taken an unprecedented three consecutive giant steps and is expected to take at least one more this year, pushing the year-end rate to the mid-4% range, the Bank of Korea is likely to accelerate rate hikes in the remaining two Monetary Policy Committee meetings (October and November) this year. Notably, in July, Bank of Korea Governor Lee Chang-yong executed the first-ever big step and indicated that “gradual increases of 0.25 percentage points are desirable” as forward guidance, but revisions seem inevitable. If the Bank of Korea raises rates by 0.25 percentage points in both October and November meetings, the rate will reach a maximum of 3.00%, potentially widening the Korea-U.S. interest rate gap to as much as 1.5 percentage points by year-end.

On the same day, Governor Lee hinted at the possibility of a big step and foreshadowed changes to forward guidance following an emergency macroeconomic and financial meeting. He stated, “The biggest change since the forward guidance is that market expectations for the Fed’s terminal rate have significantly increased to around 4% or higher, as Chairman Jerome Powell mentioned early this morning,” adding, “We expected stabilization around 4%, but expectations have changed considerably.” Lee Seung-heon, Deputy Governor of the Bank of Korea, also assessed at the ‘Market Situation Review Meeting’ that “the 0.75 percentage point rate hike at this FOMC meeting met market expectations, but the hawkish tone of the rate outlook and Chairman Powell’s remarks may increase volatility in international financial markets.”

If the widening interest rate gap between Korea and the U.S. continues, foreign capital outflows may accelerate, increasing calls for the Bank of Korea to respond with a big step. Kim Jung-sik, Emeritus Professor of Economics at Yonsei University, warned, “As the pace of U.S. tightening accelerates, the Korea-U.S. interest rate gap will widen further by year-end, increasing the likelihood of foreign investors seeking higher yields to withdraw their funds.” He added, “If the won depreciates as a result, it could raise the converted prices of imported goods, further fueling inflation.” Shin Hyun-song, Senior Economist and Head of Research at the Bank for International Settlements (BIS), emphasized at the previous day’s ‘G20 Global Financial Stability Conference’ that “the interaction among central banks in implementing monetary policy must be considered,” and stressed, “For Korea, controlling inflation is an urgent priority.”

On the other hand, there is an opposing view that excessive tightening in Korea could instead lead to a high exchange rate. Moon Hong-chul of DB Financial Investment Research Institute noted, “Historically, the won-dollar exchange rate has risen contrary to common sense when Korean interest rates were higher than U.S. rates,” adding, “In Korea’s case, if domestic interest rates rise sharply amid weak external demand, domestic consumption and growth could be damaged, further encouraging won depreciation.”

Meanwhile, the Bank of Korea noted that accumulated household debt has mainly flowed into real assets such as real estate, and that if real estate prices adjust due to rate hikes, the net debt of high-income households, which had significantly increased their debt, could expand substantially. Although the deterioration in interest income and expenses is expected to be limited with rising rates, it may be relatively more pronounced among low-income households. The Bank of Korea stated, “To mitigate the problem of disparities in debt financing scales exacerbating wealth inequality among income groups, differential application of the Debt Service Ratio (DSR) regulation should also be considered.”

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