"End of Base Rate Hike Sequence" vs "Still Possibility of Increase"

Monetary Policy in the Fog: 3 Variables... Inflation, Oil Prices, and US Interest Rates

[Asia Economy Reporter Seo So-jeong] The Bank of Korea (BOK) kept the base interest rate steady at 3.5% this month as expected, but by leaving the door open for further hikes, aftershocks surrounding future monetary policy continue. As BOK Governor Lee Chang-yong described the rate freeze on the 23rd as "stopping the car temporarily while driving on a foggy road until the fog clears," the Korean economy is engulfed in domestic and external uncertainties, plunging future monetary policy into a foggy situation. Contrary to Governor Lee's mention of the possibility of additional hikes, the market is effectively interpreting this freeze as the final step in the rate hike cycle, amplifying uncertainty about future monetary policy.

Uncertainty in Inflation Path... Persistent Core Inflation

The first uncertainty factor influencing the direction of future monetary policy is the inflation path. Governor Lee repeatedly emphasized at a press conference immediately after the rate freeze decision that this freeze was a decision focused more on inflation than on the economy. He forecasted, "The consumer price index (CPI) inflation rate will be around 5% in February, slightly lower than in January, then drop to the 4% range in March due to a significant base effect from last year's sharp rise in international oil prices, and by the end of the year, it will be in the low 3% range." The BOK has set its CPI inflation forecasts at 3.5% for this year and 2.6% for next year. According to this, there is a high possibility of inflation returning to the 2% range next year, and the decision to halt rate hikes reflects consideration of inflation slowdown over the long term.

However, uncertainty in the inflation path remains significant. In particular, the recent clear upward trend in core inflation is complicating inflation forecasts. While the CPI inflation rate peaked at 6.3% in July last year and has gradually slowed since, core inflation has continued to rise recently. Core inflation, which excludes agricultural products and petroleum products and reflects the underlying trend of inflation, rose 5.0% in January, up from 4.8% the previous month. This is the highest level since February 2009 (5.2%). Especially, the core inflation rate excluding food and energy, a key indicator monitored by the BOK, entered the 4% range in August last year (4.0%) and remained high at 4.1% in January this year.

Intense debates among Monetary Policy Board members ahead of this month's base rate decision also centered on core inflation. Governor Lee expressed concern, saying, "If public utility charges rise, there is a possibility that the secondary effects will prevent core inflation from falling quickly," and "At the beginning of the year, we assumed core inflation at around 4% would fall below 3% by the end of this year, but this is one of the many uncertain factors." Since electricity and city gas rates, which broadly affect core inflation, may rise, upward cost pressures are inevitably significant, and uncertainty about public utility charges persists. Governor Lee explained, "We preemptively factored in gas and electricity charges related to public utilities rising to last year's levels, but once actual government policies are announced, the BOK will need to revise its forecasts accordingly."

[Image source=Yonhap News]

The second variable is international oil prices. The biggest reason the BOK lowered this year's inflation forecast by 0.1 percentage points from the November projection (3.6%) in its revised economic outlook was the reduced international oil price. In November, the international oil price was expected to be around $93, but the current forecast lowered it to $84, allowing room to reduce the inflation forecast. However, this remains uncertain. With China's early reopening (resumption of economic activities) expected to accelerate recovery starting from the second quarter of this year, earlier than initially anticipated in the second half, there is a possibility that international oil prices will rise again. Volatility could also increase significantly depending on additional sanctions against Russia, Russian production cuts, and supply changes among oil-producing countries.

Major Variables in Monetary Policies of the US, Japan, and Other Key Countries

The third variable is the monetary policies of major countries such as the United States and Japan. As US employment and inflation indicators have exceeded market expectations, the market's expectations for the US terminal interest rate continue to rise. Jamie Dimon, CEO of JP Morgan Chase, the largest US bank, said on the 23rd (local time), "I doubt that the (base interest rate) will only go to the widely discussed 5% level," adding, "It could reach 6%."

Currently, the interest rate differential between Korea and the US is 1.25 percentage points, but if the US Federal Reserve (Fed) raises the base rate by 0.25 percentage points at least twice in March and May, the gap will widen to over 1.75%, the largest ever. Regarding this, Governor Lee said, "Under a floating exchange rate system, there is no appropriate level for the (Korea-US interest rate) gap," and dismissed concerns by saying, "The interest rate gap is an important factor, but it is not mechanically risky if it exceeds a certain percentage." However, he added, "If the gap widens too much, it could become a variable, so we will carefully decide monetary policy considering all options, including how much exchange rate volatility to tolerate, whether to use foreign exchange reserves to prevent concentration, and to what extent to respond with interest rates."

Recently, rising consumer inflation in Japan has also increased uncertainty related to monetary policy. Kazuo Ueda, the nominee for Governor of the Bank of Japan (BOJ), stated at a hearing on the 24th that "monetary easing policies will continue," causing the yen to weaken. However, the market is placing more weight on forecasts that Japan's monetary policy will shift to a tighter stance than before once he becomes governor.

Although uncertainty surrounding future monetary policy is increasing, the market is spreading the view that the Monetary Policy Board's decision to freeze the base rate this month effectively marks the end of the rate hike cycle that has continued for the past year and a half. To avoid an overly dovish interpretation, the governor mentioned the possibility of additional hikes, but the view is that the possibility of further hikes based on the inflation path is relatively limited.

Seungwon Kang, a researcher at NH Investment & Securities, said, "The governor still emphasizes that stabilizing inflation is the core mission rather than the economy, and if the inflation trajectory is the key criterion for monetary policy, Korea's rate hike cycle has already ended," adding, "I expect the BOK to cut rates once in the fourth quarter of this year." Jaegyun Ahn, a researcher at Shinhan Investment Corp., said, "Since mentioning a faster-than-expected economic downturn could lead to interpreting this freeze as the end of the rate hike cycle, the governor seems to have increased focus on whether the inflation path aligns with policy," and "Unlike in the fourth quarter of last year, the current domestic factors, especially the inflation path, provide conditions for monetary policy operation, which also supports the final base rate level of 3.50%."

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