Despite Korea-US-Europe's 'Continued Tightening' Threats... Growing Expectations for Interest Rate Cuts

Central Bank and Market, Different Dreams on 'Monetary Policy Direction'

Not only in Korea but also in the United States and Europe, the 'same bed, different dreams' between central banks and the market regarding the direction of monetary policy continues. Central banks have recently emphasized the need to "maintain a tightening stance" by repeatedly mentioning high inflation rates, but the market continues to focus solely on the possibility of interest rate cuts.

In Korea, although the gap between short-term market interest rates and the base rate has recently narrowed somewhat, there is still a significant difference of opinion regarding the timing of interest rate cuts. Experts explained that if this trend continues, the transmission mechanism of monetary policy may not function properly, and central bank responses are necessary.

According to financial markets and major foreign media on the 9th, in Korea, the United States, and Europe, concerns about economic recession due to high interest rates, the central banks' tightening stance, a robust labor market, and high inflation rates are mixed, leading to divergent forecasts regarding the direction of monetary policy.

In the United States, the unemployment rate (3.4%) announced by the U.S. Bureau of Labor Statistics on the 5th (local time) marked the lowest level in 54 years, showing that the labor market remains strong. However, the market strongly expects the Federal Reserve (Fed) to hold the base interest rate steady and cut rates within the year, regardless of this.

According to the Chicago Mercantile Exchange (CME) FedWatch, the probability that the Fed will hold rates steady at the June meeting is 85.8%. Although this is slightly lower than the 91.5% on the 5th, the prevailing perception remains that the Fed will not raise the base interest rate further.

Even after Fed Chair Jerome Powell made hawkish remarks on the 3rd (local time) immediately following the Federal Open Market Committee (FOMC) meeting, stating that "rate cuts are inappropriate," the market focused more on the removal of the phrase 'additional policy tightening' from the FOMC statement and interpreted the FOMC decision as dovish (favoring monetary easing).

The situation is similar in Europe. On the 4th (local time), Christine Lagarde, President of the European Central Bank (ECB), raised the base interest rate by 0.25 percentage points, saying, "We will not stop," but the market placed more weight on the reduction in the rate hike size from 0.50 percentage points to 0.25 percentage points rather than the ECB's tightening stance.

The Bank of Korea's London office explained, "Despite President Lagarde's continued intention to raise rates further, market participants focused on the perception that the tightening cycle is nearing its end and the reduced impact of previous policy rate hikes on financial conditions, evaluating this policy decision somewhat dovishly."

The Bank of Korea's Frankfurt office also analyzed, "Considering President Lagarde's mention of the need for additional rate hikes, the possibility of a 0.25 percentage point rate hike in June seems high, but the prevailing expectation is that the final rate level will not differ significantly from this."

Christine Lagarde, President of the ECB
Photo by EPA Yonhap News

In Korea, the phenomenon of short-term interest rates falling below the base rate continues, showing a gap between the central bank and the market. According to the Korea Financial Investment Association, the 1-year government bond yield is 3.339%, and the 91-day Monetary Stabilization Bond (MSB) yield is 3.276%, both below the base rate of 3.5%.

This means that although the Bank of Korea has stated it will maintain a tightening stance for the time being, the market views the tightening cycle as over and the timing for rate cuts as approaching. In fact, the Bank of Korea has repeatedly stated that rate cuts within the year are premature, but the market is highly anticipating rate cuts in the second half of the year.

Even if the base rate rises, if investors' expectations for rate cuts are strong, long-term interest rates may fall, but it is unusual for short-term rates such as the 91-day MSB to fall below the base rate. In response, Bank of Korea Governor Lee Chang-yong mentioned to reporters on the 24th of last month that "it is problematic that the 1-month and 3-month MSB rates are significantly below the base rate."

Experts see this gap between the central bank and the market as a communication issue.

Thomas Helbling, Deputy Director of the Asia and Pacific Department at the International Monetary Fund (IMF), said at a press briefing held at Songdo Convensia in Incheon on the 4th, "The U.S. also had situations in the past where there was a gap between market rates and policy rates, but it was ultimately a communication problem," and explained, "(The central bank) showed some narrowing of the gap after sufficient communication."

In fact, after the Bank of Korea recently made efforts to align short-term rates with the base rate, yields on 91-day Certificates of Deposit (CDs) and 91-day MSBs have been rising.

Lee Chang-yong, Governor of the Bank of Korea, is attending the 56th Annual Meeting of the Asian Development Bank (ADB) 'Governors' Seminar' held on the 3rd at Songdo Convensia in Yeonsu-gu, Incheon. [Image source=Yonhap News]

Some express concerns that if such a mismatch continues, the transmission mechanism of monetary policy may not function properly.

Kang Kyung-hoon, a professor of business administration at Dongguk University, wrote in a Hana Financial Focus commentary yesterday, "Concerns are being raised that the Bank of Korea's control over high inflation may be hindered as short-term interest rates in the money market decline," and pointed out, "Monetary policy affects the real economy through various transmission channels, including interest rate channels, exchange rate channels, expectation channels, and credit channels, and some of these may not function properly."

Jay Pearce, an IMF advisor, also pointed out at a press briefing, "Even if there is a gap between market rates and policy rates, we have often seen it narrow eventually," but warned, "If the narrowing does not happen gradually and a sudden shock occurs, it could have (negative) effects on the financial market."

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