6 Consecutive Base Rate Holds... BOK at a Crossroads of Growth Rate and Inflation (Comprehensive Report 2)

Bank of Korea Monetary Policy Board to Decide Policy Direction on 19th
Economic Uncertainty and US Monetary Policy Uncertainty Persist
Israel-Palestine War and Oil Prices as Variables
Inflation Target Convergence Delayed Beyond Initial Expectations
Unanimous Decision to Hold Rates, Divergent 3-Month Outlooks Draw Attention

Lee Chang-yong, Governor of the Bank of Korea, is striking the gavel at the Monetary Policy Committee meeting held at the Bank of Korea in Jung-gu, Seoul on the 19th. Photo by Joint Press Corps

Amid growing concerns over an economic downturn, the Bank of Korea (BOK) decided on the 19th at the Monetary Policy Committee meeting to keep the base interest rate steady at 3.5% per annum for the sixth consecutive time. With the outbreak of war between Israel and the Palestinian armed group Hamas and ongoing uncertainties in U.S. monetary policy, the BOK intends to hold rates steady and observe future developments.

Although there are concerns about the widening interest rate gap between South Korea and the U.S., the BOK judged that it would be difficult to raise rates further due to significant uncertainties surrounding domestic economic recovery and the risk of financial instability caused by increased financial interest burdens. Contrary to the government's 'low in the first half, high in the second half' economic outlook, the recovery strength of the Korean economy has not been clear since the fourth quarter, and the ongoing impact of China's economic slowdown has reduced the need for additional tightening.

At the Monetary Policy Committee meeting on the 19th, the BOK unanimously decided to keep the base interest rate at 3.50%. The committee had paused its rate hikes in February after a series of increases over one and a half years since August 2021, and this marks the sixth consecutive hold following the previous August. With the BOK's decision to maintain the base rate, the interest rate gap with the U.S. (5.25?5.50%) remains at a record high upper limit of 2.00 percentage points.

In the resolution of the Monetary Policy Committee, the rationale for the hold was explained as follows: "Although the inflation rate is expected to continue its underlying downward trend, uncertainties in inflation and growth outlooks have increased due to prolonged monetary tightening in major countries and heightened geopolitical risks. The pace of inflation decline is expected to be more gradual than anticipated, and given the need to monitor the rising household debt trend, maintaining the current tightening stance is deemed appropriate."

Consumer price inflation is projected to fall to the low 3% range by the end of this year and continue a gradual slowdown next year. However, due to elevated international oil prices, exchange rate impacts, and the Israel-Hamas conflict, upward risks to inflation have increased, potentially delaying the convergence of consumer price inflation to the target level beyond initial expectations. The committee also noted, "Core inflation is expected to continue its underlying downward trend due to weakening demand pressures, but the pace of decline may be more gradual than initially expected due to the ongoing pass-through effects of accumulated cost increases."

Core Inflation Trending Downward... International Oil Prices Remain a Variable

One reason the BOK decided to hold rates this month is that although inflation has recently rebounded, it has not significantly deviated from the BOK's forecast in the broader trend. The consumer price inflation rate in September (year-on-year) rose to 3.7%, but the core consumer price index, which reflects the effect of monetary policy, has shown a steady downward trend for three consecutive months at a similar level, indicating that the current base rate is at a restrictive level. However, the rapidly evolving Israel-Palestine war has intensified volatility in international oil prices, posing a risk of reigniting inflationary pressures. Additionally, uncertainties in U.S. monetary policy remain unresolved, and domestic economic instability continues, so the BOK's stance is to hold the base rate and monitor future inflation trajectories.

Another reason cited for the hold is the recent sharp increase in financial interest burdens, which raises concerns about worsening household debt defaults. Professor Seok Byung-hoon of Ewha Womans University’s Department of Economics stated, "Although household and corporate debt delinquency rates are still low, the rapid increase in delinquency rates across all loans is problematic. The delinquency rate on real estate project financing (PF) is also rising quickly, so further rate hikes would increase principal and interest repayment burdens, leading to higher delinquency rates and financial instability." This, in turn, could reduce both consumption and investment, further exacerbating the economic downturn.

Recession-Type Growth... Recovery of Growth Rate in the Second Half is Key

One of the critical variables for the BOK's future monetary policy operation is the economic trend. South Korea's economic growth rate (quarter-on-quarter) contracted by 0.3% in the fourth quarter of last year, then improved slightly to 0.3% in the first quarter and 0.6% in the second quarter of this year, but it is difficult to predict whether this trend will continue. The recent growth recovery is largely characterized as 'recession-type growth,' occurring amid declines in both exports and imports, with imports falling more sharply. There is no sign yet that this situation will resolve. For a clear recovery in growth, exports and consumption need to revive, but recent geopolitical risks in the Middle East, rising international oil prices, and increasing household debt have heightened uncertainties.

In particular, the recent rise in international oil prices acts as a negative factor causing both inflation and economic recession simultaneously. Professor Seok pointed out, "If oil prices rise due to the Israel-Palestine war, production costs for companies increase, which partly passes on to prices, causing inflation. But it doesn't end there; companies reduce some production to mitigate profit losses. Since South Korea imports all its energy, increased energy import costs reduce net exports and worsen the trade balance, inevitably lowering GDP growth."

Exports, a core component of the Korean economy, have declined year-on-year for 12 consecutive months through August, mainly in petroleum products and semiconductors. The BOK expects exports to rebound in the second half of this year, but with the U.S. economy, which has been a significant support for Korean exports instead of China, expected to slow down next year, and rising international oil prices potentially pushing import prices up, the rebound is not expected to be substantial.

Lee Chang-yong, Governor of the Bank of Korea, is presiding over the Monetary Policy Committee meeting held on the 19th at the Bank of Korea in Jung-gu, Seoul. Photo by Joint Press Corps

Weak Consumption Amid High Interest Rates... Semiconductor Rebound Uncertain

Experts have also raised concerns that weak consumption will continue in the second half of the year. Private consumption increased by 1.6% in the third quarter of last year but then declined by 0.5% in the fourth quarter, rose 0.6% in the first quarter, and fell 0.1% in the second quarter this year, showing a sluggish pattern. Consequently, the contribution of domestic demand growth, considering consumption and investment, is -0.8%, dragging down overall growth. Given South Korea's high household debt and over 4 million multiple debtors, it is difficult for households to increase consumption under the current high-interest-rate environment.

Uncertainties also remain in the semiconductor market, a key export sector for South Korea. Semiconductor exports last month reached $9.99 billion, recovering to the highest level this year, and semiconductor spot prices, a leading indicator, have bottomed out and are gradually rising. However, recent U.S. export restrictions on low-end artificial intelligence (AI) chips to China have expanded risks surrounding the semiconductor market. While the immediate impact of the U.S.'s tightened export controls on China may be limited for Korean industries, the possibility of market contraction cannot be ruled out.

On the positive side, China's economy is gradually recovering, which benefits exports. The previous day, China's National Bureau of Statistics reported a 4.9% year-on-year economic growth rate for the third quarter, significantly exceeding market expectations of 4.4%. Other economic indicators released the same day, including industrial production (4.5%), retail sales (5.5%), and unemployment rate (5.0%), also showed improvement. If China's economy recovers, exports to China will increase, accelerating growth and easing the BOK's monetary policy burden.

The international oil price trend resulting from the Israel-Hamas war is also an important consideration for the BOK's monetary policy. Following a hospital explosion in the Gaza Strip causing hundreds of deaths, concerns have risen that the Israel-Palestine conflict could escalate into a broader Middle East war, pushing international oil prices up about 2% that day. Brent crude, the international oil price benchmark, closed at $91.5 per barrel, with some forecasts consistently predicting a breakthrough of $100. Rising oil prices increase inflationary pressures, which could delay the BOK's timing for rate cuts.

The excessively high household debt ratio relative to GDP is also likely to exert upward pressure on the BOK's base interest rate. Considering that household loans continue to increase even with the base rate at 3.5%, if the BOK officially pivots its policy, expectations of rising housing prices could surge again, causing household debt to balloon. This would negatively affect consumption and growth rates in the medium to long term.

Professor Ha Jun-kyung of Hanyang University's Department of Economics said, "The BOK is hesitant to raise rates further due to the accumulated high private debt." He added, "With financial regulators controlling bank loan expansions, if financial regulations continue at the government level, the rationale for raising rates may diminish." Professor Ha also noted, "Exports are showing signs of gradual recovery, but consumption is not increasing, and the government is not actively increasing fiscal spending. Therefore, the current situation of holding the base rate is expected to continue for some time."

Governor Lee Chang-yong: "One MPC Member May Lower Rates Within Next Three Months"

Lee Chang-yong, Governor of the Bank of Korea, is presiding over the Monetary Policy Committee plenary meeting held on the 19th at the Bank of Korea in Jung-gu, Seoul. Photo by Joint Press Corps

At a press conference following the Monetary Policy Committee meeting, Governor Lee Chang-yong stated, "The consensus among Monetary Policy Committee members is that the pace of inflation decline will be slower than the path predicted in August." He added, "There is significant uncertainty about achieving a 2% inflation rate by the end of December next year, but we expect inflation to converge to that level, albeit at a slower pace than forecasted in August."

Governor Lee also revealed that although the committee unanimously agreed to hold the base rate at this meeting, opinions diverged regarding the base rate outlook over the next three months. He explained, "Among the six MPC members excluding myself, five believed that the possibility of further rate hikes should remain open. They argued that inflationary pressures have increased and the timing for inflation convergence has been delayed, necessitating stronger tightening than in the August meeting."

He continued, "Among those five members, one emphasized the need for preemptive measures to prevent further deterioration of household debt, while another pointed out that due to significant policy uncertainties, the base rate could either be raised or lowered over the next three months."

Regarding concerns about rising household debt, Governor Lee dismissed the idea of immediate rate hikes, saying, "We will consider micro-level adjustments first, and if those are insufficient, macro-level adjustments through interest rates might be considered, but we are not at that stage yet." He added, "Household debt in South Korea is ultimately a real estate issue, and monetary policy should not target changes in real estate prices."

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