- The Bank of Korea continued to normalize monetary conditions by increasing the benchmark interest rate by 25 basis points to 1.25%.
- Persisting inflationary pressures point to further gradual interest rate increases through 2022.
The Bank of Korea (BoK) raised its benchmark Base Rate by 25 basis points to 1.25% following the January 14 monetary policy meeting (chart 1). The decision marks the third hike in the ongoing monetary normalization phase, which began in August 2021. The prior rate increase took place at the November meeting; we assess that the back-to-back hikes highlight policymakers’ rising concerns regarding South Korea’s inflation outlook.
While the BoK’s benchmark interest rate has now been lifted back to its pre-pandemic level, we expect further gradual increases throughout the year. We foresee the Base Rate closing 2022 at 2.0%. BoK Governor Lee Juyeol pointed out that interest rates in South Korea are still accommodative and that further monetary normalization is needed according to the country’s economic situation. Governor Lee implied that monetary normalization will remain in place in the near term, highlighting that even a rate increase to 1.50% cannot be considered monetary tightening. Indeed, with elevated inflation, South Korea’s real interest rates remain deeply in negative territory.
Inflationary pressures are building in South Korea, requiring a monetary policy response. Prices at the headline level increased by 3.7% y/y in December 2021 (chart 2), well above the BoK’s 2% inflation target. The central bank expects inflation to continue to “run in the 3% range for a considerable time”. Indeed, our estimations point to above-3% inflation through the third quarter of 2022, after which we expect inflation to ease slightly to 2.8% y/y by the end of the year. Meanwhile, core inflation has picked up as well, reaching 2.7% y/y in December 2021. The BoK expects it to remain “considerably above 2% this year”. On the back of elevated core price pressures and higher inflation expectations by the general public, as well as our expectation for firms’ price-setting behaviour to partially pass elevated input costs to consumers once domestic demand strengthens, South Korea’s inflationary pressures are unlikely to prove transitory. Accordingly, we do not foresee headline inflation returning to the BoK’s 2% target before 2024.
Financial stability considerations play a role in the BoK’s monetary policy decisions. Low interest rates have contributed to an elevated household debt level and rapidly rising house prices. While the pace of such gains is set to moderate, the BoK will continue to monitor the risk of a buildup of financial imbalances. Moreover, the central bank will closely assess the financial impact of the US Federal Reserve’s monetary normalization efforts. Considering that the South Korean won has recently faced a weakening bias against the US dollar, we assess that the BoK’s next interest rate hike will likely be soon after the Fed’s approaching rate liftoff.
The BoK’s policymakers seem confident that South Korea’s economic recovery remains on track despite uncertainties related to the pandemic. While we expect some weakening in South Korean export growth over the coming months, external sector prospects remain broadly favourable. A rebound in domestic demand will likely be somewhat delayed due to the evolving COVID–19 situation. Nevertheless, South Korea’s labour market has continued to improve with solid increases in employment, underpinning household spending prospects. Following an estimated 4% expansion in 2021, we expect South Korea’s real GDP to grow by 3% this year, in line with the BoK’s forecasts.
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