Won-dollar interest rates gap widen to historic high

The U.S. Federal Reserve (Fed) raised its base rate by 0.25 percentage points on Wednesday, judging that there is a need to reduce inflationary pressure despite continuing financial instability, including the bankruptcy of four small-and medium-sized banks due to interest hikes. Fed Chairman Jerome Powell said, “It will take time to ease inflation, and lowering rates is inappropriate.” The remarks are demoralizing for the global financial market, which has been expecting a freeze on the interest rates followed by a downward trend within the year.

With the latest raise, the U.S. base rate has reached the highest levels in 16 years since 2007 at 5.0-5.25%, which marks the 10th consecutive increase since March last year. The authorities said the U.S. consumer price index, which stood at 5.0% in March, is still supposed to be far above the Fed’s inflation target of 2%. The Bank of Korea (BOK), which has frozen interest rates twice at 3.5%, is finding itself in a tight spot as the Korean central bank is poised to make the last rates decision for the first half this year, while witnessing the U.S. and Korea interest rates inversion widening to a historic high of 1.75 percentage points after 22 years. This also means that foreign capital outflows from the local capital market will likely increase over the year.

The biggest problem is the won-dollar exchange rate, which remains below 1,300 won despite the dollar's recent weakness. In the real effective exchange rate calculated by the Bank for International Settlements (BIS), which reflects price fluctuations between trading countries, the Korean won ranked 60th out of 64 countries surveyed in March, meaning that the relative value and purchasing power of the won are low. Only Japan, which was ranked 64th, Columbia, Turkey, and Norway ranked lower than Korea.

If the interest rate inversion continues, the exchange rate will only grow further unstable. Moreover, it is unlikely that the value of the won will recover anytime soon as Korea has been running a trade deficit for 14 consecutive months and the foreign currency earned from overseas has diminished accordingly. Even though international oil prices have dropped significantly recently, Korea was not able to reap the benefits owing to the high exchange rate. In March, Korea’s import prices fell by 1.8% in dollar terms but rose by 0.8% in won.

Under those circumstances, there is no guarantee that we can be relieved by the fact that the consumer price index fell slightly to 3.7% last month. The high exchange rate is increasing the burden on energy imports and adding pressure on power and gas prices to increase. Agricultural product prices may rise again anytime soon due to abnormal weather and the escalation of the Ukraine conflict. The BOK and the government should not be obsessed with the specter of stagnation and must keep a tight rein on inflation through shrewd management of exchange rates.