Bank of Korea Lowers Growth Outlook, Raises Inflation Forecast... Tougher Year Ahead (Comprehensive Report 2)

Base Interest Rate Held Steady at 3.5% for 7 Consecutive Times
Export Recovery Slower Than Expected
Concerns Deepen Over Weak Consumption and Investment

Lee Chang-yong, Governor of the Bank of Korea, is striking the gavel at the Monetary Policy Direction Decision Meeting of the Monetary Policy Committee held on the 30th at the Bank of Korea in Jung-gu, Seoul. Photo by Joint Press Corps

On the 30th, the Bank of Korea (BOK) lowered its economic growth forecast for next year to 2.1%, signaling a global economic slowdown. This is a 0.1 percentage point decrease from the 2.2% forecast issued in August, reflecting downside risks to the economy due to slower-than-expected export recovery and sluggish consumption amid high interest rates. As concerns over economic slowdown grew, the BOK kept the base interest rate unchanged at 3.50% for the seventh consecutive time.

On the other hand, the consumer price inflation forecast for next year was revised upward from 2.4% to 2.6%. With the BOK lowering the growth forecast while raising the inflation outlook, a 'stagflation' scenario?characterized by economic stagnation alongside rising prices?is expected to persist.

The Monetary Policy Board of the Bank of Korea held a meeting on monetary policy direction starting at 9 a.m. that day and decided to maintain the base interest rate at the current 3.50%. The decision to hold the rate was unanimous among the board members. The board had consecutively kept the rate unchanged in meetings held in February, April, May, July, August, and October this year, and by maintaining the rate at this final meeting of the year, it extended the streak to seven consecutive holds. BOK Governor Lee Chang-yong explained, "The inflation path is expected to be higher than initially projected," adding, "We will maintain a sufficiently long and tight monetary policy stance."

The decision to hold the rate for the seventh time was influenced by the fact that October's consumer price inflation rate exceeded expectations at 3.8%, and the timing for reaching the inflation target (2%) is expected to be delayed, which would normally argue for a rate hike. However, the sluggish export recovery due to the economic slowdown in China and the significantly increased financial interest burden made additional rate hikes burdensome.

In particular, the perception that the U.S. Federal Reserve's (Fed) rate hikes have effectively ended has eased concerns about the widening interest rate gap between Korea and the U.S., supporting the BOK's decision to hold rates. Christopher Waller, a prominent hawk on the Fed Board, recently expressed confidence that the current policy is in a "good place" to slow growth and bring inflation back to the 2% target. As expectations grow that the Fed's rate hikes have ended, market anticipation for rate cuts next year is increasing. Since the interest rate gap between the U.S. and Korea has widened to a record high of up to 2 percentage points, further widening could trigger instability in financial and foreign exchange markets. Therefore, the end of U.S. rate hikes reduces the burden on Korea's monetary policy decisions.

Joo Won, head of economic research at Hyundai Research Institute, said, "At the December Federal Open Market Committee (FOMC) meeting, the Fed is expected to hold rates due to recent inflation stabilization and concerns over real economic recession, and rate cuts are expected to begin as the global economic slowdown intensifies next year." He added, "Due to domestic financial market instability caused by high interest rates, the possibility of a Fed pivot (monetary policy shift), and weak domestic economic recovery, Korea is unlikely to raise rates further." Although the high inflation in the high 3% range and rising household debt remain burdens, recent easing of the won-dollar exchange rate and international oil prices suggests that monetary policy decisions will focus more on economic slowdown and financial stability.

Even if Semiconductors Recover Next Year... Concerns Over Weak Domestic Demand and Exports

In its revised economic outlook released that day, the BOK maintained this year's economic growth forecast at 1.4% but lowered next year's forecast to 2.1%. Previously, in August, the BOK had lowered next year's growth forecast from 2.3% to 2.2% while keeping this year's forecast at 1.4%, the same as in May. Thus, within just over three months, it further reduced the growth forecast for next year. Considering that the OECD raised South Korea's growth forecast for next year from 2.1% to 2.3% the day before, the BOK's lower forecast indicates a more pessimistic view of the Korean economy next year. Compared to the Ministry of Economy and Finance (2.4%) and the International Monetary Fund (IMF, 2.2%), the BOK's forecast is relatively low.

The BOK's downward revision of next year's economic growth forecast reflects significant uncertainty surrounding the economy. Although the semiconductor sector is gradually recovering from its worst phase, the tightening effects of the past two years are fully materializing, leading to deteriorating domestic demand centered on consumption, which is the biggest concern. The outlook that major economies affecting Korea, such as the U.S. and China, may experience sluggish growth next year is also interpreted as a reason for the BOK's conservative growth forecast.

First, the semiconductor sector, a key export item for Korea's economy, is expected to show signs of recovery next year. According to the Korea Customs Service, exports from the beginning of this month to the 20th reached $33.79 billion, a 2.2% increase compared to the same period last year, largely influenced by the recovery in semiconductor trade volume, the largest export item. The rebound in prices for memory products such as DRAM and NAND flash indicates that semiconductor exports have bottomed out and are reviving. The BOK's November Business Survey Index (BSI), released the day before, also showed a significant improvement in manufacturing sentiment centered on semiconductors, electronics, video, and communication equipment.

However, excluding semiconductor exports, many risk factors remain. In particular, consumption, which had compensated for semiconductor weakness through pent-up demand following the COVID-19 pandemic, has recently deteriorated. Inflation remains high in the 3% range, and the full impact of high interest rates has begun to dampen consumer sentiment. The non-manufacturing business sentiment index this month fell to its worst level in 1 year and 11 months since December 2020. The Korea Development Institute (KDI) and the Korea Institute for Industrial Economics and Trade (KIET) recently forecast relatively low economic growth rates of 2.2% and 2.0%, respectively, citing weak private consumption as a key factor.

Concerns also abound that the sluggish housing market and massive household debt will weigh down next year's growth. Although the real estate market showed signs of price rebounds centered on Seoul earlier this year, it has recently stalled again due to the impact of high interest rates. Experts predict that while semiconductor and other facility investments may slightly increase, construction investment is expected to decline due to rising unsold housing units. Since Korea has a large amount of household debt related to real estate, such as mortgage loans, a sluggish housing market negatively affects consumption. As of the end of September, household credit balance reached 1,875.6 trillion won, and if the high interest rate environment continues into next year, the increased household interest burden will inevitably hit consumption and domestic demand. The continued rise in interest burdens on households and businesses due to high interest rates, along with financial market instability such as real estate project financing (PF) defaults, further complicate monetary policy challenges.

China's Economic Recovery Remains Key to Korea's Growth Next Year

Amid contrasting trends in semiconductors and domestic demand, the degree of China's economic recovery is expected to be a major variable for Korea's growth next year. China experienced significant slowdowns in both exports and domestic demand this year due to financial difficulties faced by major real estate developers such as Evergrande and Country Garden. However, recent continuous stimulus measures by the authorities have somewhat improved the situation. China's economic growth rates were 4.5% in Q1, 6.3% in Q2, and 4.9% in Q3, approaching the initial annual growth target of 5%. Accordingly, organizations such as the OECD and IMF have recently raised their growth forecasts for China next year slightly.

However, the OECD and IMF still expect China's growth rate next year to be in the low 4% range, lower than this year, suggesting limited positive spillover effects from China's recovery. Professor Heo Jun-young of Sogang University's Department of Economics said, "Since China recorded 3% growth last year, even if it achieves the 5% target this year, it is not an impressive figure." He added, "Even if China's economy rebounds next year, unlike in the past, China's domestic demand has advanced significantly, so the benefits to the Korean economy may not be substantial."

The U.S. economy, which has divided opinions regarding its outlook, is also a key variable. If the U.S. economy continues to grow next year without a hard landing, exports to the U.S., especially automobiles that performed well this year, could continue to increase. Conversely, if the opposite occurs, Korea's exports will inevitably be hit. While Goldman Sachs and UBS forecast a soft landing for the U.S. next year, some market participants predict a hard landing, reflecting divergent views. Professor Heo said, "For Korea, which is heavily dependent on external factors, a sudden downturn in the U.S. economy is frightening," adding, "If it only slows moderately, there is no strong reason for the BOK to drastically lower its growth forecast next year."

Potential Growth Rate Decline Forecast... Concerns for the Following Year

Lee Chang-yong, Governor of the Bank of Korea, is presiding over the Monetary Policy Committee meeting held on the 30th at the Bank of Korea in Jung-gu, Seoul. Photo by Joint Press Corps

The BOK forecasted the economic growth rate for 2025 at 2.3%. This implies that Korea's economy will find it difficult to regain past growth momentum. With aging and low birth rates intensifying and no clear new growth engines identified, a decline in potential growth rate is inevitable. Governor Lee Chang-yong previously mentioned that Korea's neutral interest rate would decline after the high inflation period passes. Recently, Agustin Carstens, General Manager of the Bank for International Settlements (BIS), agreed with Lee's view, anticipating declines in Korea's potential growth rate and neutral interest rate. Professor Heo Jin-wook of Incheon National University's Department of Economics said, "Next year, growth is expected to return to the 2% potential growth path as exports improve," but added, "Most agree that the potential growth rate will decline very rapidly in the future."

The BOK raised its consumer price inflation forecast for next year from 2.4% to 2.6%. Domestic inflation is expected to continue a gradual easing trend due to weakening demand pressures and declines in international oil and agricultural prices, but it is projected to exceed the August forecast path due to higher-than-expected cost pressures. The Monetary Policy Board explained, "Consumer price inflation will gradually decline to around 3% in the first half of next year," and "The annual inflation rate is forecasted at 3.6% this year and 2.6% next year." Inflation for the following year is projected at 2.1%.

The BOK's downward revision of next year's growth forecast and upward revision of inflation forecast have drawn attention to their implications for future monetary policy. The prolonged Ukraine crisis, Middle East conflicts, global economic slowdown, and China's sluggish economy are slowing export recovery and weakening growth momentum. The continuation of tight monetary policy to combat high inflation is causing investment and consumption to contract, which is worrisome. Professor Seok Byung-hoon of Ewha Womans University's Department of Economics said, "The recovery speed of Korea's key export item, semiconductors, is slower than expected, delaying export recovery," adding, "With weak exports and consumption, and the government unable to boost spending due to tax revenue shortfalls, a worst-case scenario of growth in the 1% range next year is not impossible."

The delayed convergence to the inflation target (2%) is also a variable. October's consumer price inflation in Korea was 3.8%, exceeding expectations and reigniting inflation concerns. The government, which had promoted the idea of 'inflation stabilization in October,' is belatedly managing inflation, but the slowdown is not rapid, so the timing for reaching the inflation target is expected to be delayed. A delayed achievement of the inflation target will inevitably postpone Korea's interest rate cut timing.

Final Interest Rate Reached, Rate Cuts Expected in Q3 Next Year

Lee Chang-yong, Governor of the Bank of Korea, is presiding over the Monetary Policy Direction Decision Meeting of the Monetary Policy Committee held on the 30th at the Bank of Korea in Jung-gu, Seoul. Photo by Joint Press Corps

As perceptions spread that the base interest rates in the U.S. and Korea have effectively reached their peak, market attention is turning to rate cuts. Kwon Hyo-sung, an economist at Bloomberg Korea, said, "Due to slower-than-expected inflation easing, the BOK has revised its expected timing for rate cuts from Q2 to Q3 next year," adding, "The U.S. economy is also more resilient than expected, so rate cuts are unlikely until mid-next year." Professor Yoo Hye-mi of Hanyang University's College of Economics and Finance said, "Since inflation is easing faster in the U.S. than in Korea and due to the interest rate gap between Korea and the U.S., it will be difficult for Korea to cut rates before the U.S.," predicting, "If the U.S. cuts rates around the end of Q2 next year, the BOK will cut rates in Q3."

Governor Lee said at a press conference following the Monetary Policy Board meeting that opinions among board members on the interest rate outlook for the next three months were divided. Among the six board members excluding Governor Lee, four expressed that "the possibility of additional rate hikes should be kept open," while two believed "it is appropriate to maintain the base rate at the current level." One board member who had previously suggested keeping the door open for rate cuts at last month's meeting withdrew that opinion, citing reduced uncertainty.

Regarding the timing for convergence to the 2% inflation target, Governor Lee mentioned that Korea is expected to reach it by the end of next year or early 2025, while the U.S. will likely achieve it in the middle to late 2026. He stated, "We will maintain a tight monetary stance until we are confident that inflation has sufficiently converged to the 2% target," adding, "This could take longer or shorter than six months, but realistically, it is likely to take longer." He also warned, "While high interest rates next year may cause difficulties for vulnerable groups, these should be supported through fiscal policy targeting them," cautioning, "Premature stimulus measures could only raise real estate prices."

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