The Monetary Policy Board of the Bank of Korea has decided to take a “big step” rate increase by 0.5 percentage points from 1.75 percent to 2.25 percent. The key rate, which was 0.5 percent in July 2021, has surged by 4.5 times in just a year. After the meeting, BOK Governor Rhee Chang-yong said pulling inflation is more urgent than offering economic stimulus, implying that the central bank will focus on combating inflation at this time when economic downturn and inflationary pressures are together affecting the economy.
The BOK’s big rate increase by twice as much as ordinary rate increase is unprecedented. The monetary policy board’s rate hike for three consecutive sessions is also the first in its history. The extraordinary nature of the latest rate increase points to the severity of inflation pressures. The consumer inflation growth in June approached an all-time high of 6 percent since November 1998, when the Asian financial crisis broke. Taking into account the increase in electricity, gas, and water prices, which have not yet been reflected in the statistics, the inflation growth rate could reach 7 to 8 percent. Inflation expectations, the rate at which people expect prices to rise in the future, have also reached the peak in 10 years and two months. The likelihood that stress and anxiety will drive up wages and prices of goods is high.
The most worrisome prospect is the scenario where shock rate hike leads to insolvency of vulnerable households and marginal businesses that owed excessive debt. Where household debt is over 1,800 trillion won, a rate hike of 0.5 percentage points will increase household interest rate burden by 6.8 trillion won. Some estimates show that there are 304 incorporated companies whose sales revenue are insufficient to pay even interest. If overborrowed households and zombie companies fall into insolvency in succession due to the failure to pay debt, the overall economy, including the housing and financial market, will descend into chaos. The debt restructuring of vulnerable households and businesses is necessary, and the monitoring of non-banking financial companies must be strengthened.
Although the BOK took a big step, it is difficult to consider that the current interest rate is sufficient to achieve price stability. The United States will take a “giant step” of 0.75 percentage points to tackle its 41-year high inflation rate, which will lead to an interest rate gap reversal between South Korea (2.25 percent) and the U.S. (2.5 percent).
This may cause a ripple effect of capital outflow, depreciation of the value of won, and increase in export prices and domestic prices of goods and services. This is certainly the worst-case scenario to even imagine. The BOK must sign a currency swap agreement with the U.S., thereby blocking the possibility of capital outflow, and take further rate hikes to fight inflation. It is time to minimize the negative impact of rate increase and tighten austerity measures.