[Insight & Opinion] The Pros and Cons of Interest Rate Cuts

The U.S. Federal Reserve (Fed) held its policy rate steady on the 29th of last month. This is due to growing concerns about a rebound in inflation caused by U.S. President Donald Trump's tariff policies. With the Fed delaying the pace of interest rate cuts, attention is focused on whether the Bank of Korea will lower rates in February. It is necessary to weigh the pros and cons of an interest rate cut.

First, lowering interest rates can stimulate the domestic economy and revive the livelihood of ordinary people. So far, high interest rate policies have frozen domestic demand. Since the implementation of the inflation targeting system in 1998, the Bank of Korea has raised the base rate only six times in 27 years, and among these, it has increased the rate by more than 1.75 percentage points only twice. Excluding increases by other governments before and after their terms, the Roh Moo-hyun administration raised rates by 1.75 percentage points, and the Yoon Suk-yeol administration raised them by 2.0 percentage points. Both administrations experienced severe domestic demand recessions due to excessive rate hikes. Normalizing high interest rates through rate cuts can increase suppressed consumption and investment, thereby recovering the domestic economy. Additionally, it can mitigate the shock of export declines caused by U.S. tariff policies and the slowdown in growth due to current political turmoil.

Reducing the spread of financial insolvency can prevent the Korean economy from being exposed to financial crisis risks. As high interest rates persist, concerns are growing that real estate project financing (PF) insolvencies will increase further this year due to the construction industry's downturn. Moreover, the domestic recession raises the possibility of bankruptcies not only among small business owners but also some large corporations. Interest rate cuts can revive the real estate market, reduce bankruptcies in the construction sector, and lower interest burdens to prevent the spread of financial insolvency.

The biggest cost of lowering interest rates is the risk of inflation reemerging. As the economy improves due to rate cuts, prices may rise again. However, the causes of inflation in the U.S. and Korea differ. In the U.S., inflation is demand-pull, driven by increased aggregate demand in a booming economy, whereas in Korea, inflation is cost-push, caused by rising production costs such as exchange rates and electricity prices despite economic stagnation. In demand-pull inflation, rate cuts can increase aggregate demand and raise prices, but in cost-push inflation, even with lower rates, inflation is unlikely to rise due to economic stagnation. Rather, factors such as exchange rates, electricity prices, and crude oil price increases drive inflation rebounds more than interest rates.

Exchange rate increases also make policymakers hesitant to cut rates. Rate cuts can widen the interest rate gap with the U.S., leading to capital outflows and a higher exchange rate, which can again raise prices. However, the main causes of the current exchange rate increase are import price rises due to U.S. tariff policies and a strong dollar, rather than the interest rate gap between Korea and the U.S. In fact, the prolonged high interest rates have caused a downturn in the Korean stock market, prompting foreign investors to withdraw capital and raising the exchange rate. Another cost of rate cuts is increased household debt and rising real estate prices. However, apart from monetary policy, loan regulations and real estate controls can significantly mitigate these side effects of rate cuts.

Domestically, the Korean economy is experiencing a deepening domestic demand recession due to high interest rates and political turmoil, while externally, it is exposed to export shocks from U.S. protectionism and China's slowing growth. Comparing the pros and cons of rate cuts, the benefits of reviving the domestic economy to prevent bankruptcies of small and medium-sized businesses and the spread of financial insolvency outweigh the relatively low risk of inflation reemergence. Monetary authorities should normalize excessive high interest rates to revive the domestic economy and absorb the ongoing domestic political turmoil and the tariff shocks from Trump’s policies, which are expected to continue.

Kim Jeong-sik, Professor Emeritus, Department of Economics, Yonsei University