"During the Past Four Instances of KR-US Interest Rate Inversion, Exchange Rate Fluctuations Were Not Significant"

US Interest Rate Hikes to Curb Excess Liquidity
Exchange Rate Volatility Increases as Real Economy Faces Crisis

Source=KCCI

The Korea Chamber of Commerce and Industry (KCCI) analyzed four past periods of interest rate inversion between Korea and the U.S. and found that exchange rate volatility caused by real economic shocks after U.S. interest rate hikes was greater than during the inversion periods themselves.

According to the report titled "Characteristics and Implications of Exchange Rate Fluctuations during Korea-U.S. Interest Rate Inversion Periods," released by KCCI on the 20th, there have been a total of four instances of interest rate inversion between Korea and the U.S. since the Bank of Korea began announcing its policy rate in May 1999, and exchange rate fluctuations during these periods were relatively small.

In fact, during the first inversion period (June 1999?March 2001) and the second inversion period (August 2005?September 2007), the exchange rate tended to decline as the interest rate inversion gap widened.

During the recent third inversion period (March 2018?February 2020) and the fourth inversion period (September 2022?present), the exchange rate showed a slight increase and some instability but did not experience large fluctuations.

U.S. Interest Rate Hikes to Curb Excess Liquidity Amplify Exchange Rate Instability When Transmitted to Real Economy Crisis

KCCI argued that more attention should be paid to the ripple effects on the U.S. and global economies following U.S. interest rate hikes rather than the inversion periods themselves. When the Federal Reserve’s high interest rate policy to curb excess liquidity translates into a real economy crisis, exchange rate instability intensifies.

Indeed, after the latter part of the first inversion period, the 'dot-com bubble burst' and after the second inversion period, the 'Lehman Brothers collapse' caused the won-dollar exchange rate to surge sharply in a short period. Even during the first inversion period, the exchange rate was on a downward trend until the dot-com bubble burst occurred.

Source: Korea Chamber of Commerce and Industry

On the other hand, during the third and fourth inversion periods, although the aftermath of U.S. interest rate hikes caused stock market crashes, deflation, and financial instability, these did not spread further, resulting in relatively limited exchange rate instability.

KCCI explained, "Through the past four interest rate inversion periods, we could discern the pattern of how interest rate changes affect the foreign exchange market and the real economy," adding, "Excess liquidity in the U.S. leads to interest rate hikes, which then impact the real economy and subsequently cause global exchange rate instability."

However, the direction depended on the magnitude of the U.S. interest rate hikes and the extent of the shock to the U.S. real economy. During the first and second rate hike periods, the U.S. policy rate exceeded 5%, imposing significant burdens on the real economy, whereas during the third rate hike period, the peak rate was a relatively moderate 2.5%.

Kim Hyun-soo, head of the Economic Policy Team at KCCI, stated, "Analyzing the past four U.S. rate hike periods and the subsequent won-dollar exchange rate trends, it was found that the U.S.-Korea interest rate gap itself was less of a trigger for global recessions and exchange rate instability than the shocks to the U.S. real economy. Therefore, managing fundamentals that can withstand external economic shocks is more important."

He added, "Since our economy is externally exposed, it inevitably is influenced by U.S. monetary policy and real economic movements, but the amplitude and duration depend on the strength of our economy. Policy focus should be on mitigating potential vulnerabilities in the financial sector such as household debt and real estate project financing (PF), and on escaping the trade deficit structure that could affect the foreign exchange market in the medium to long term."

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