- The Bank of Korea continued to normalize monetary conditions by raising the benchmark interest rate by 25 basis points to 1.0%.
- Elevated inflation, solid economic growth prospects, and rising financial imbalances warrant gradual interest rate hikes through 2022.
The Bank of Korea (BoK) opted to raise the benchmark interest rate by 25 bps to 1.0% following the November 25 policy meeting (chart 1). The decision marks the second hike in the current monetary normalization phase, which kicked off in August. Given persistent uncertainties that reflect a resurgence of COVID–19 cases in South Korea, we expect the BoK to maintain a measured approach to monetary normalization over the coming months. Indeed, today’s decision was not unanimous as one of the seven Monetary Policy Board members voted for the rate to remain unchanged.
According to BoK Governor Lee Juyeol, South Korean policymakers remain open to a possible next hike in Q1 2022, yet he highlighted that the exact timing remains uncertain. Today’s meeting was the last one scheduled for 2021. We expect the benchmark repo rate to reach its pre-pandemic level of 1.25% in the first quarter. Monetary normalization is justified by three key considerations: 1) the nation’s inflationary pressures are intensifying; 2) the economic outlook remains sound; and 3) financial imbalances continue to rise.
Inflation has continued to accelerate in South Korea. Headline inflation reached 3.2% y/y in October (chart 2), well above the BoK’s 2% inflation target. We expect inflation to remain above 3% for the rest of the year; price pressures will likely weaken somewhat next year as global supply chain bottlenecks ease. While the BoK forecasts inflation to decelerate back to the 2% target in 2022, we estimate that headline inflation will hover around 2½% y/y for most of the year. We note that core inflation has accelerated sharply and the general public’s inflation expectations have risen. Moreover, we expect firms’ price-setting behaviour to take into account elevated input costs and partially pass them to consumers in line with strengthening domestic demand. Against this backdrop, we do not foresee headline inflation returning to the 2% mark before 2023.
Despite COVID–19 uncertainties, the BoK’s policymakers seem confident that South Korea’s economic recovery remains on track. Indeed, the central bank expects the nation’s output gap to close in the first half of 2022. While we expect some weakening in South Korean export growth over the coming months, external sector prospects remain broadly favourable. Domestic demand is subject to downside risks that reflect the evolving COVID–19 situation; nevertheless, employment has continued to rise and firms’ investment intentions remain sound, pointing to solid domestic activity. We expect South Korea’s real GDP to expand by 4% in 2021 and 3% in 2022, in line with the BoK’s forecasts.
Due to low interest rates, South Korean household debt burden and house prices continue to climb higher. Accordingly, preventing financial imbalances from worsening significantly has become an increasingly important policy priority. The BoK will pay close attention to financial stability in the face of approaching monetary policy changes in major economies. Indeed, we assess that the US Federal Reserve’s monetary policy normalization timeline will influence the BoK’s future rate decisions.
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