[Insight & Opinion]KOSPI 5000 Era and the "Interest Rate Policy Dilemma"

Deflating Asset Bubbles and Excess Liquidity
Urgent Need to Close the Gap with the Real Economy
"Gradual Rate Hikes" Worth Considering

The Bank of Korea's interest rate policy has fallen into a dilemma. From the perspective of economic recession, it would be appropriate to lower interest rates. However, given the current situation in which multiple factors are unfolding at the same time, including the exchange rate, inflation, stock prices, and rising apartment prices in Seoul and the greater Seoul metropolitan area, there is also a need to raise rates. Recently, the Bank of Korea made the decision to freeze rates for the fifth consecutive time. In order for interest rates to properly function as a policy tool, it is necessary to carefully weigh the pros and cons of a rate hike.

The biggest cost of an interest rate hike is considered to be a "deepening of the economic downturn." The fortunes of our industries are currently diverging. Exports of semiconductors and automobiles are strong, but other key industries such as petrochemicals, steel, and shipbuilding are losing competitiveness and are in a slump. The downturn in the construction industry, which is closely tied to domestic demand, is even more serious. If rates are raised in the midst of an economic recession, the downturn could worsen further. Another cost is the potential for financial distress among households and companies as interest burdens increase and spread. Bankruptcies among small business owners are already rising due to the slump in domestic demand, and there are growing concerns that household delinquency rates will also rise going forward. This concern is heightened because, as the government implements a land transaction permit system to stabilize housing prices, households and small business owners face restrictions on selling their homes, which could otherwise help prevent them from becoming insolvent.

On the benefit side, a rate hike could absorb excess liquidity in the market and thereby prevent a collapse of stock and housing price bubbles. The real economy is in a recessionary phase, but stock prices alone have risen sharply, widening the gap between the real and financial sectors and raising concerns about a bubble. In the short term, the Korea Composite Stock Price Index (KOSPI) has even exceeded the 5,000 level, further amplifying these concerns. The housing price bubble is also a problem. The government is enforcing a housing transaction permit system that prohibits purchases by non-end users and is also imposing strict lending regulations. Nevertheless, housing prices are not being contained because fiscal spending has increased and low interest rates have caused liquidity in the market to expand excessively. A rate hike is being called for as a measure to curb this trend, since it can absorb excess liquidity. It is also needed to narrow the gap with market interest rates. Market rates have been on the rise as government bond issuance increases due to fiscal deficits. In the meantime, the Bank of Korea's policy rate has been frozen, widening the gap. In such circumstances, it is all the more necessary to raise the policy rate to narrow the difference with market rates and enhance the effectiveness of monetary policy. An interest rate hike can also help stabilize the exchange rate and inflation. One driver of the rising exchange rate is the increase in stock investment in the United States. This appears to have been triggered by the United States' high growth rate and competitiveness in new industries, but it is also partly due to the decline in the value of the won caused by our low interest rates and expanding money supply. By raising rates, liquidity can be reduced and the value of the won can be increased, thereby helping to stabilize the exchange rate. Headline inflation can also be lowered, which in turn reduces inflation expectations along with the exchange rate.

When we compare these factors, we can see that the benefits of a rate hike outweigh the costs. However, implementing an actual rate increase is not easy. This is because cuts in the U.S. policy rate are anticipated, and a rate hike here could trigger a further slump in domestic demand and financial distress. Political factors such as elections also cannot be ignored. It is appropriate for the monetary authorities to be cautious about a rapid rate hike. However, a gradual increase in interest rates is worth considering. We need to reduce market liquidity so that our economy can escape the twin risks of bubble collapse and financial crisis. The government must also guard against fiscal inflation that could be caused by fiscal deficits and government bond issuance stemming from excessive fiscal spending. It is time for a prudent shift in interest rate policy.

Kim Jeongsik, Professor Emeritus, Department of Economics, Yonsei University

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