Base Rate Held at 3.5%, Growth Rate Lowered to 1.4%... Bank of Korea Lowers Outlook (Comprehensive Report 2)

1.4% Growth Rate Forecast, Lowest Level
Next Year’s Outlook Also Lowered to 2.3%
US Tightening Signals Imminent Recession
Government Policy Implementation Expansion Also Not Possible

Lee Chang-yong, Governor of the Bank of Korea, is holding a press conference after the regular meeting of the Monetary Policy Committee held on the 25th at the newly constructed headquarters of the Bank of Korea in Jung-gu, Seoul. [Image source=Yonhap News]

On the 25th, following the Bank of Korea's decision at the Monetary Policy Committee meeting to keep the base interest rate steady at 3.5% per annum, it also downgraded this year's real Gross Domestic Product (GDP) growth forecast to 1.4%. This revision reflects a 0.2 percentage point cut in the growth outlook over three months due to continued export sluggishness and a slowdown in consumer recovery. The Bank of Korea's forecast of 1.4% is the lowest among domestic and international institutions. As the global economic slowdown continues to lower growth expectations, there are speculations that the timing for an interest rate cut could be approaching as early as the end of this year.

The Bank of Korea's Monetary Policy Committee held a meeting on the same day and decided unanimously to maintain the base interest rate at 3.50% per annum. This freeze marks the third consecutive hold following last month, after the committee paused rate hikes in February for the first time in one and a half years since August 2021, signaling the end of the rate hike cycle. With the base rate held steady, the gap between Korea's rate and that of the United States (4.75?5.00%) remains at a record high upper bound of 1.75 percentage points.

The reason behind the Bank of Korea's decision to hold rates this month is the gradual easing of inflationary pressures. Since the consumer price inflation rate in April fell to the 3% range for the first time in 14 months, the Bank intends to observe future inflation trends by maintaining the current rate. However, in its revised economic outlook, the Bank kept the consumer price inflation forecast unchanged at 3.5%. While inflationary pressures are expected to ease over the long term, core inflation is declining more slowly than anticipated, and recent increases in electricity and gas prices add variables that could affect future inflation trajectories.

The growth forecast for this year was lowered from 1.6% to 1.4%, reflecting the underwhelming effect of China's reopening and the semiconductor industry's downturn, which is a key export sector, leading to continued trade deficits. Jo Young-moo, a research fellow at LG Economic Research Institute, said, "The main variable for monetary policy going forward is economic growth. If growth expectations continue to decline to the low 1% range, calls for interest rate cuts within the year will increase."

Bank of Korea Governor Lee Chang-yong stated, "The domestic economy will continue to experience sluggish growth for the time being, but from the second half of the year, gradual recovery is expected due to easing IT sector downturns and the ripple effects of China's economic recovery." He added, "The consumer price inflation rate has significantly decreased due to base effects from last year's sharp rise in international oil prices but will slightly increase afterward, fluctuating around 3% until the end of the year." He emphasized, "The Monetary Policy Committee will monitor growth trends and operate monetary policy with attention to financial stability, ensuring inflation stabilizes at target levels over the medium term."

Delayed Effects of China's Reopening and IT Sector Recovery

The Bank of Korea's decision to lower this year's GDP growth forecast to 1.4% indicates the challenging domestic and international environment surrounding the Korean economy. Amid high-intensity tightening by major countries like the United States and an approaching recession, the expected benefits from China's reopening have been delayed, and there are few factors outside domestic demand to drive economic growth, making it difficult to expect a recovery in growth rates in the second half of the year. Experts predict that even if the economy partially recovers in the latter half, it will be difficult to escape a 'low growth' phase for the time being.

The newly forecasted growth rate of 1.4% by the Bank of Korea is among the lowest compared to major domestic and international institutions, except for the Korea Institute of Finance (1.3%) and Standard & Poor's (S&P, 1.1%). If this forecast holds, it will be the lowest growth rate recorded outside of crisis years such as the 1998 Asian financial crisis (-5.1%), the 2009 global financial crisis (0.8%), and the 2020 COVID-19 pandemic (-0.7%). The Bank also lowered next year's growth forecast slightly from 2.4% to 2.3%.

Korea's plunge into low growth is mainly attributed to the delayed recovery of China's economy, which has the greatest impact on Korean exports and growth. Recently, China's production, consumption, and investment have all fallen short of expectations, compounded by the adverse event of the yuan breaking the 7 yuan per dollar level, known as 'Pochi.' A shaky Chinese economy and yuan inevitably lead to a rise in the won-dollar exchange rate and a worsening current account balance. Moreover, the United States has requested Korea to restrain semiconductor exports to China, Korea's largest market for semiconductors, making it difficult even to maintain market share.

Expectations for expanded government fiscal spending to drive economic growth are also low. National tax revenue in the first quarter of this year decreased by 24 trillion won compared to last year, and many analyses suggest that annual tax revenue will fall short of initial projections. The government is focusing fiscal spending in the first half of the year, anticipating a 'high-low' economic trend, leaving limited fiscal capacity for the second half. Considering the Yoon Seok-youl administration's fiscal soundness policy, it is unlikely that the government will prepare supplementary budgets to stimulate the economy.

If China's economy begins to recover in earnest from the second half, it could help Korea's growth recovery, but structurally, it is expected to be difficult to escape low growth in the 1?2% range for a considerable period. Professor Heo Jin-wook of Incheon National University's Department of Economics explained, "Due to demographic changes, Korea's potential growth rate is inevitably declining. It is likely that average growth will be in the mid-to-high 1% range after the year following next." Professor Kang Sam-mo of Dongguk University's Department of Economics emphasized, "Aging and low birth rates negatively affect recessions and potential economic growth rates. Under these circumstances, to promote growth recovery, deregulation and encouragement of corporate investment to improve economic efficiency are the only options."

Core Inflation Declining Slowly as a Variable

Although the Bank of Korea has held rates steady for three consecutive times this month, anticipating an overall decline in inflationary pressure, the persistence of inflationary sparks remains a key variable for future monetary policy. Contrary to market expectations of a slight downward revision, the Bank maintained this year's inflation forecast at 3.5% in its revised economic outlook. Next year's inflation forecast was lowered from 2.6% to 2.4%.

Experts point out that while inflationary pressure is expected to ease in the second half of the year, the slower-than-expected decline in core inflation is a major factor influencing future inflation paths. The government raised electricity rates by 8 won per kWh and city gas rates by 1.04 won per MJ (megajoule) starting from the 16th, so the impact of public utility price hikes on inflation needs to be closely monitored. Park Seok-gil, an economist at JP Morgan, said, "Although the annual impact of electricity and gas price hikes on inflation may be diluted, the ripple effect of public utility prices on overall inflation is significant. As domestic demand stabilizes in the second half, price pressures from the demand side will gradually ease, lowering inflation rates, but the slow decline in core and service inflation is a factor that monetary policy cannot overlook."

Inside and outside the government, there are analyses that electricity and gas price hikes will raise this year's consumer price inflation by 0.1 percentage points, but since public utility price increases could intensify service price inflationary pressures, close attention to future trends is necessary. Kim Jeong-sik, emeritus professor of economics at Yonsei University, said, "Uncertainties remain in international oil prices, raw material prices, and agricultural and fishery product prices, and the psychological effect of public utility price hikes is expected to be significant. Although electricity rates have been adjusted, the situation is insufficient, and there is still a possibility of further increases."

With the Bank of Korea holding rates steady for three consecutive times and lowering this year's economic growth forecast to the lowest level among domestic and international institutions, some predict that the Bank may begin cutting rates as early as this year. Moon Hong-chul, a researcher at DB Financial Investment, said, "For the Bank of Korea to start cutting rates this year, it must at least send some signals to the market in the first half. By lowering the growth forecast to 1.4% and anticipating a slower-than-expected economic recovery in the second half, the Bank will gradually weigh the timing of rate cuts."

On the other hand, with U.S. monetary policy, won-dollar exchange rate trends, and financial instability remaining key variables, some believe the U.S. will cut rates first. Jo Young-moo of LG Economic Research Institute said, "Despite the record 1.75 percentage point gap between Korean and U.S. rates, the won has not weakened significantly, nor has foreign capital outflow intensified. However, if Korea cuts rates before the U.S., the rate gap will widen further, so Korea will wait to see clear signs of U.S. rate cuts before lowering its own rates."

Governor Lee Chang-yong: "Don't Assume Interest Rate Hikes Are Impossible"

While the market is confident that the terminal rate has been reached, Governor Lee said that all Monetary Policy Committee members, except himself, believe the possibility of a terminal rate level of 3.75% during this rate hike cycle should remain open. At a press conference, he explained, "The possibility of further hikes remains because although consumer inflation is easing, core inflation is declining more slowly than expected. We need to observe whether the U.S. Federal Reserve will stop or continue raising rates and the impact on the foreign exchange market."

Governor Lee added, "Although the Bank of Korea is unlikely to raise rates further, the market reacts as if we are only bluffing. We have kept the option open and will make decisions based on inflation and data. Please do not assume Korea can never raise rates." He noted that Australia also raised rates unexpectedly.

He dismissed the possibility of rate cuts within the year, stating, "It is premature to mention the timing of cuts before there is clear evidence that consumer inflation is converging to 2%." He explained that hasty rate cuts could trigger financial instability, so cuts will be considered only after careful review. He also added that the downgrade of the growth forecast from 1.6% to 1.4% reflects slower-than-expected recovery in the IT sector and China's economy.

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