Despite Unprecedented US-Korea Interest Rate Gap, Exchange Rate Falls... "In Line with Market Expectations, No Shock"

US-Korea Interest Rate Gap Widens by 2%p but Exchange Rate Starts to Fall
No Immediate Market Shock as Expected
US Additional Rate Hike Key... Powell 'Ambiguous'
If Tightening Continues, Korea's Hike Inevitable... "On Thin Ice"

Deputy Prime Minister and Minister of Economy and Finance Choo Kyung-ho is delivering opening remarks at the Emergency Macroeconomic and Financial Meeting held at the Bankers Hall in Jung-gu, Seoul on the 27th. Photo by Kang Jin-hyung aymsdream@

On the 26th (local time), the U.S. Federal Reserve (Fed) raised the benchmark interest rate by 0.25 percentage points, widening the Korea-U.S. interest rate gap to a record high of 2 percentage points. However, the won-dollar exchange rate started off lower that day, showing relatively stable behavior. This increase was already anticipated by the market, and the recent Korea-U.S. interest rate gap itself has not had a significant impact on the exchange rate, which is interpreted as the reason for the mild market shock.

However, since Fed Chair Jerome Powell left open the possibility of raising or holding rates in September, there remains a risk of increased won-dollar exchange rate volatility and capital outflow concerns. The Bank of Korea, facing the largest-ever Korea-U.S. interest rate gap and recent economic slowdown worries, is expected to face a difficult decision ahead of next month’s Monetary Policy Committee meeting, as it is challenging to either lower or raise rates under these circumstances.

Korea-U.S. Interest Rate Gap at '2%p'... Won-Dollar Exchange Rate Starts Lower

On the 27th, in the Seoul foreign exchange market, the won-dollar exchange rate opened at 1,271.1 won, down 3.4 won from the previous trading day. Overnight, the Fed raised the benchmark interest rate by 0.25 percentage points to 5.25-5.50% at the Federal Open Market Committee (FOMC) regular meeting, widening the gap with Korea (3.50%) to a maximum of 2 percentage points, but the impact on the exchange rate remains limited. The won-dollar exchange rate had rebounded to 1,283.4 won ahead of the FOMC on the 21st but then turned downward again, maintaining a recent trend around the 1,270 won level.

That morning, the Bank of Korea held a "Market Situation Review Meeting" chaired by Deputy Governor Lee Seung-heon to assess the international financial market situation and its potential impact on domestic financial and foreign exchange markets. The Bank explained that the FOMC outcome was in line with expectations, and the market saw a slight decline in U.S. Treasury yields and a weaker dollar due to expectations of the end of the rate hike cycle. Deputy Governor Lee said, "Since it was reconfirmed that future Fed rate decisions will be data-dependent, uncertainty regarding the direction of monetary policy is expected to continue."

Photo by Jinhyung Kang aymsdream@

Market attention is focused on the Fed’s next moves. Chair Powell did not clarify whether rates will be raised or held at the September FOMC. For now, major global investment banks generally maintain the view that this Fed hike will be the last. The Bank of Korea’s New York office explained in a local intelligence report that "Powell’s assessment that data in June and July met expectations, while stating that further rate hikes depend on data, and his favorable evaluation of the June Consumer Price Index (CPI) acted as dovish signals (preference for monetary easing)."

Although the Korea-U.S. interest rate gap has widened to 2 percentage points, if the Fed does not raise rates further, the Bank of Korea is unlikely to pursue additional hikes. Raising the benchmark rate could negatively impact the already fragile domestic economy and, more importantly, could trigger financial instability such as a second Legoland or Saemaeul Geumgo incident or real estate project financing (PF) defaults. Given that foreign securities (bonds + stocks) have seen net inflows for five consecutive months, the Bank lacks justification to raise rates solely based on the Korea-U.S. interest rate gap.

Jerome Powell, Chairman of the U.S. Federal Reserve (Fed), is holding a press conference after concluding the Federal Open Market Committee (FOMC) regular meeting at the Federal Reserve building in Washington DC on the 26th (local time). [Image source=Yonhap News]

Possibility of Bank of Korea Rate Hike if U.S. Raises Rates Further

However, since Chair Powell has not completely ruled out further rate hikes, there is a possibility that won-dollar exchange rate spikes and capital outflow concerns could resurface. The Bank of Korea’s Washington representative stated in a report that "the Fed is expected to maintain the option of further rate hikes until it is confident that inflation is moving toward the 2% target, continuing discussions on the conditions and timing of policy rate increases." If the U.S. July CPI, to be announced next month, rebounds or geopolitical risks push up grain and energy prices, the Fed could again consider a rate hike in September.

From the Bank of Korea’s perspective, a Korea-U.S. interest rate gap widening to 2.25 percentage points is a significant burden. Bank of Korea Governor Lee Chang-yong said at a press conference after the Monetary Policy Committee meeting on the 13th, "All six MPC members are open to raising the benchmark rate to 3.75%," citing the "possibility of further Fed rate hikes" as the reason. Deputy Governor Lee also said that "there is a possibility of increased volatility in domestic and international financial markets due to changes in inflation and economic conditions in major countries and related policy expectations," and that "the Bank will carefully monitor related market conditions."

Currently, there are opinions that even a 2 percentage point Korea-U.S. interest rate gap carries significant risks. Professor Kim Hong-gi of Hannam University’s Department of Economics pointed out, "Maintaining an interest rate gap at this level is like walking on thin ice," adding, "It is not a rational decision to increase preemptive risk factors in a country like Korea with a highly open capital market." Professor Kim said, "Since U.S. inflation has not yet been controlled, there is a possibility of further hikes," and "if an unexpected shock occurs, capital outflows will happen and have a huge impact on the domestic foreign exchange market, but Korea does not have the capacity to withstand such shocks."

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